Exploring Scale: The Advantages of Thinking Small

When it comes to thinking about scale, the assumption held by corporate leaders since Henry Ford’s day has been that bigger is better. The advantages of large-scale operations are clear: Fewer managers are needed; plant, equipment and labor are used more efficiently; logistics are less complicated and so on. In many industries, executives subscribe to the concept of “minimum efficient scale,” a theory suggesting that operations smaller than a certain size cannot be cost-effective and hence are not commercially viable. The minimum output thought to be efficient varies by industry, from 200,000 vehicles for an automotive factory to 5 million tons of steel for an integrated steel mill to 8 million barrels of beer for a global brewery.

In recent years, the notion that scale economies are the main driver of competitiveness has led to mergers in such service businesses as banking, cable television and even funeral homes. The logic of minimum efficient scale was also a factor in the dot-com boom, as managers strove to “scale up” rapidly in the hope that their companies’ size would sink competitors and serve as a barrier to entry by potential newcomers.

But a single-minded focus on increasing scale doesn’t always bring happy returns. Large, centralized operations can have the effect of limiting the opportunities for innovation, impeding customer responsiveness, stunting employee development, and numbing sensitivity to industry and environmental changes. Many companies in the airline and steel industries, to take just two prominent examples, have suffered from the single-minded pursuit of large scale.

In our research, we have found that small-scale operations provide significant advantages in four areas.1 They allow companies to locate hot spots and tap into local knowledge networks; make it possible to respond more rapidly to customer needs and to trends in regional demand; enable companies to monitor potentially disruptive technologies; and help hold down labor costs while developing managerial talent. Although these topics have been discussed individually in recent years, they have never been pulled together to illustrate the hidden benefits of small-scale approaches to corporate needs.

The point is not that companies should abandon traditional thinking about scale; in many situations, bigger is indeed better because of the cost efficiencies that size provides. But sometimes efficiencies can mask opportunities. Executives who develop a deeper understanding of scale and learn when it is better to “think small” can have a potentially huge impact on their companies’ long-term success.

Tapping Into Local Knowledge Networks

The research and development function is a good example of an area in which large-scale thinking has prevailed. Many companies merge their R&D activities into one or more central facilities around the world. The belief is that such concentration is easier to control, allows knowledge to be transferred efficiently and makes it easier to integrate the company’s research agenda. But there are disadvantages to a rigid adherence to this practice. By centralizing their R&D efforts, companies lose touch with developments in “hot spots” — areas where pathbreaking research and development is being conducted.

It is well known that companies cluster geographically into hot spots to derive benefits from proximity — nearness to supply-chain partners, academics, a highly trained labor pool and so on. Hot spots are also sites of knowledge creation, and companies can tap into a variety of knowledge networks by establishing small-scale R&D operations in several locations.

Consider the biotechnology hub that has developed in and around Cambridge, Massachusetts. In the 1990s, Cambridge became home to a significant concentration of companies interested in the development of biotech research tools that would, for example, help identify small-molecule drug candidates. Several pharmaceutical companies set up satellite research labs in the city: Hoechst-Rhone Poulenc (currently known as Aventis) in 1997, Pfizer in 1999 and Amgen in 2001. By virtue of their facilities in Cambridge, these industry giants are able to get an early read on promising discoveries and to set a course for their own research.

Now imagine what happens when scientists in a Cambridge-based company discover a new type of technique or tool, such as an antibody. Researchers outside the area might have to wait to learn about the discovery until the results are published in a scientific journal, six months or more after the fact. Until then, they would not be able to learn from the approach the scientists took and use it to guide and expedite the discovery process for the effective treatment of a disease they are focusing on. But in a hot spot like Cambridge, the existence of informal networks, discussions of research in academic seminars, and consulting and sponsorship arrangements with top academic researchers can cut that time dramatically. That allows companies to choose the right strategies and appropriate tools to develop new drugs based on the discovery. Interestingly, the informal discussions of results do not lead to the faster development of the drug under study —once the drug is patented, further development (until it is certified by government agencies) can be done elsewhere. It is at the fundamental and “pre-competitive” research stage that the informal collaboration in hot spots is so important.

In Cambridge, pharmaceutical companies also learn about startups and small outfits that might be suitable partners or acquisition targets. To that end, Pfizer specifically located its small-scale discovery lab in a building that also housed several small biotech companies; in 2001, it took a stake in one such startup, BioTrove, in order to engage in joint research.

Not all industries have hot spots, and their emergence can be hard to predict. Thirty years ago, it was not obvious which area of the United States would emerge as its high-tech crucible — Dallas was as likely as Silicon Valley.2 Establishing a small-scale facility in a potential growth area is a low-risk strategy in which a company can essentially take out a real option on a potential hot spot. Biogen, for example, was an early presence in the Cambridge biotech market. The company was founded in Geneva in 1978, but in 1983, sensing that a new hot spot might develop, it opened a small site in Cambridge. At the time, European legislation restricted biotech research, and Biogen knew it needed a foothold in the United States, where the market was large and potential funding from the National Institutes of Health and venture capital firms was enticing. Finally, in 1987, Biogen shifted its full research activities to Cambridge.

By starting out small, Biogen avoided overcommitting to the fledgling research community developing in the area’s universities. When a critical mass started to form, it was poised to change the scale of its operation, take advantage of new sources of funding and ideas, and become one of the leaders in the new hot spot.

Hot spots do not stay hot forever. Near Cambridge, the area along Route 128 was once a hot spot for minicomputers, but the cluster’s knowledge network became too introverted and subsequently missed developments in other industry concentrations. Companies that take real options on small-scale sites in different regions can avoid the risk of being blind to changes happening beyond the corporate center. It’s equally important to keep the flip side in mind: Breaking the R&D function into smaller units is not an end in itself. Companies need to maintain a balance between their efficient large-scale facilities and innovation-sensing small-scale sites in selected hot spots.

Responding to Customers

The ability to share knowledge with others in a network is not the only benefit that comes with smaller operations. Large companies can also gain by setting up shop closer to their customers. By establishing facilities of smaller scale, they can more quickly give their customers what they need, when they need it.

Six years ago, the Pittsburgh-based glass and industrial-coating maker PPG Industries built several satellite plants close to its customers’ vehicle-manufacturing factories. Until that time, PPG would ship glass products in large quantities to those factories, where workers would unpack the material, sequence it for installation on the vehicles and attach components such as the buttons needed for connecting rearview mirrors and the lift plates for door glass. Since building the new facilities, PPG ships the glass in bulk directly to the small sites and offers just-in-time sequencing; that is, the company delivers glass to the auto factories in the order and quantity needed for that hour’s production, with all the necessary attachments already installed. The satellite plants, which have fewer than 100 employees each, help ensure good capacity utilization at PPG’s scale- and capital-intensive float-glass and fabrication plants where windshields and other automotive glass products are manufactured.

PPG’s proximity to the businesses it supplies has been a boon for everyone involved. PPG has benefited from having a better understanding of its customers’ needs, thus increasing the likelihood that relationships will last over the long term. The vehicle manufacturers benefit because they can move labor-intensive assembly tasks to a lower-cost supplier and reduce the logistical and managerial complexity of handling the integration activities in-house.

Supplier relationships are not the only ones that can benefit from a broader view of what constitutes efficient scale. End customers can also have their needs better tended to by companies that rethink traditional notions. In the United Kingdom, grocery retailer Tesco operates three store sizes: “metro” stores, micro-outlets in cities that are stocked with essential grocery items; regular stores located close to residential areas that offer the usual comprehensive lineup of grocery products; and “extra” stores, megafacilities located on the outskirts of major cities and close to traffic arteries that offer groceries as well as clothing, hardware and a variety of services. The small-scale metro stores are only slightly larger than traditional corner shops, but they offer a predictable level of quality at supermarket prices and thus provide strong competition to other players in this segment. By operating stores of varying size, Tesco is able to attract customers with a variety of needs and expand into new sectors.

Retail giants like Home Depot and Wal-Mart are starting to explore outlets that diverge from their traditional reliance on “big boxes.” Home Depot is building facilities that are half the size of its usual stores. In doing so, it seeks to compete with businesses that operate on a smaller scale, such as Ace Hardware, a co-op of local hardware stores. The Ace stores have combined their buying power to develop the large-scale economies in purchasing and marketing necessary to compete with Home Depot, and they have been able to leverage their small-scale stores to develop a better understanding of the particular needs of communities and build relationships with local customers.

Likewise, Wal-Mart is opening what it calls “neighborhood markets” of 40,000 square feet, the size of regular supermarkets. The company’s goal is to sustain its growth by establishing a presence in communities that are not served by big-box outlets. Much of Wal-Mart’s (and Home Depot’s) success, of course, has come from its large-scale purchasing and logistics operations. But the company is not insensitive to the advantages that lie in adjusting store inventory to reflect the needs of the local market, and it gives store managers the power to make small purchasing decisions in response to local opportunities. Other retail chains like Kmart have not given their managers such freedom in the past and are only now starting to explore that option.

Rethinking Human Resources

Another facet of the organization that can benefit from small scale is human capital.

At the managerial level, companies can develop people more quickly by putting them in charge of small operations, where they will have the opportunity to prove themselves capable of handling the full range of duties required in a large operation. If their performance is weak, the effect on overall corporate performance will be relatively minor. Companies are thus able to more rapidly screen a younger managerial cohort than that typically found in organizations where senior executives have had to work their way up the long career paths associated with large-scale operations.

In the automobile industry, an astonishing number of top managers have developed their abilities at small plants in South Africa. Examples include Keith Butler-Wheelhouse, who became president of Saab following his stint in South Africa and is currently CEO of Smiths Group; Jürgen Schrempp, CEO of DaimlerChrysler; Carl-Peter Forster, CEO of Opel; and Bernd Pischetsrieder, CEO of Volkswagen. The ascendancy of these corporate leaders is impressive, considering that the combined output of the operations they managed corresponds to that of an average-sized auto factory in the United States or Europe.

At the rank-and-file level, smaller operations give companies the opportunity to tap into labor markets without disrupting them. A large automotive assembly factory, for example, employs 5,000 or more workers. The need to build such a facility in an area that has sufficient workers within commuting distance will put a strain on the local labor market and put upward pressure on wages. But when companies take advantage of smaller scale, they have more flexibility — they have more potential sites of operation and can choose their employees more selectively. Wages are likely to stay more in line with prevailing rates. In addition, in the absence of unions (smaller operations are less attractive to organizers), companies can have more flexible work rules and can make greater use of performance-based pay. Steel minimills are a case in point: at Indiana’s Steel Dynamics, hourly workers can double their base wages of approximately $10 per hour if they meet production targets.

This issue isn’t limited to frontline employees — it can also apply to the costs of skilled labor. In the airline sector, labor costs account for 30% to 40% of revenue. A pilot’s salary, however, depends on the size of the airline. A regional pilot’s salary ranges from $16,500 to $43,000, whereas a pilot at a major national airline earns from $23,000 to $140,000.3 Because of union-related rules, a captain at a national airline rated for a 747 would get paid at that high rate even if he or she were flying a 20-seat regional jet. As a result, the cost per seat on every flight would be around $6 higher than it would be on a regional carrier. To reduce such costs, large airlines collaborate with (and in some cases own) one or more regional carriers, whose staff comes under different union agreements. Rethinking scale in the airline sector opens opportunities to re-examine the skill levels required to fly a commercial plane.

Driving Innovation

Small-scale operations provide opportunities to explore radically new technologies — which may otherwise be exploited by new entrants that are much more motivated than major players to experiment with products or services that cannot command a large share of the market.

The decline of integrated steel producers shows how different ways of thinking about scale can generate opportunities based on new technology. Integrated mills have extremely high fixed costs, and high utilization of capacity is critical to lowering their production costs. An integrated mill optimally produces 4 million to 6 million tons of steel per year. Minimills, by contrast, are significantly cheaper to build and generally have annual capacities of about 1 million tons per year. Comparisons of labor costs suggest that minimills need between 14% and 25% of the labor of integrated mills for each ton of steel produced. As a result of that and other advantages, minimills will produce about half of the steel in the United States, up from 21% a decade ago.4

Integrated steel producers initially did not view minimills as a threat because their use of scrap metal as starter material relegated them to lower ends of the market. Led by Nucor, however, the minimill industry continuously improved the quality of its steel, and Nucor eventually figured out how to make flat-rolled steel slabs (used to make the sheet metal that goes into automobiles, for example) that were only 20% of the thickness of that of traditional mills. The thinner initial castings produced at Nucor enabled it to produce hot-rolled thin-gauge steel at a huge cost advantage over cold-rolled steel, and the thinner-gauge slabs could be rolled into sheet steel more rapidly with less equipment. The capital costs of this approach are less than half those associated with traditional integrated steel production.

While minimills started at the low end of the market and have been moving up, the reverse is also possible. Beer production, for example, has long been driven by scale economies. As the diameter of pipes or vats increases by a small fraction, equipment costs increase relatively little but capacity increases a lot. As a result, it makes great sense to increase the size of mashing tuns and fermentation vats or to move to higher-volume continuous processes that make use of larger pipes. However, the higher-volume processes also result in higher-volume products that have to be shipped long distances. That level of production opens up opportunities for low-volume producers in niche markets that can generate alternative varieties of beer and bypass such processes as pasteurization or filtration (or both).

Small beer producers (microbreweries and pub breweries) correctly believed that some consumers prefer variety in their beer and make their choice a personal statement. Specialized equipment producers, such as Micropub Systems International, created equipment to serve this market profitably. Used in more than 30 locations, including a casino in the Netherlands Antilles and a U.S. military base in South Korea, Micropub’s products eliminate a key component of the beer-making process: the storage, grinding, cooking and mashing of grain. Those tasks are done instead at a large-scale facility in Wisconsin. Micropub then extracts most of the water from the resulting mash and ships the product to small breweries around the world. The local brew pubs or restaurants can then offer locally produced beer using only a brew kettle, fermenting agents and storage tanks. The “footprint” for beer production is reduced dramatically in the process. For example, a brewery starting from scratch with the grain would require as much as 500 square feet of space to make 50 kegs per month, but it could produce that amount in only 68 square feet if the grain arrived ready for fermenting. The use of prepared raw materials also means that a small-scale operation can get by without a brew master, a savings of $45,000 or more per year.

Recently, major beer companies have been taking an interest in the niche market of craft brews. Coors, for example, established Blue Moon Brewing to produce Blue Moon Ales for national distribution. And Anheuser-Busch took an equity stake in small-scale brewers such as Redhook Ale Brewery in Seattle. Establishing new facilities and investing in existing successful small-scale operations is another means to monitor the opportunities associated with small scale.

In the airline sector, discount airlines have stirred up the established players, but the discounters still obey the laws of large scale: They use one type of aircraft on the assumption that fixed costs are better managed when divided among 100 or more passengers. Now some companies are challenging this scale-driven concept by seeking to provide point-to-point air taxi service as a competitive alternative for short-haul business travel. (For more on this developing service, see “Commercial Air Travel and the Failure of the Hub Approach.”)

Air taxi service cannot be cost-competitive if it uses existing types of aircraft, however, and the need for alternatives is driving technological innovation. Both entrepreneurs and established companies are at work developing aircraft that makes use of new lightweight materials and designs.5 At around 33 feet in length, these aircraft weigh less than half of a typical sport utility vehicle.6 The new planes promise operating costs of about 60 cents per mile versus $1.50 for traditional vehicles like the Learjet or Cessna Citation, and they will be fast, too: A new generation of engines is being developed that provides twice the thrust-to-weight ratio of current small-airplane engines. To increase the commercial viability of air taxis, NASA has been working since 1995 on systems that will allow small aircraft to operate safely while using airports that are not staffed with air traffic controllers, permitting much better use of all available aircraft and airspace. In the air travel business, the need to operate on a smaller scale is driving the industry’s innovations.

Taking a Small Step Forward

Most people would agree that small-scale operations have value — but, they would object, their value is hard to quantify in monetary terms. Such uncertainty explains why many decisions in favor of small-scale operations have been made for easily understood financial reasons rather than to obtain the benefits we have outlined here. We agree that companies must continue to focus on costs and pursue efficiencies of scale, but we also advocate the conscious pursuit of the broad range of advantages that can result from small-scale operations.

To do that, companies must look both inside and outside —at small competitors, supply-chain partners, customers and so on. By examining small-scale activities that others are experimenting with, companies can uncover radically new technologies and managerial approaches. To evaluate and leverage opportunities as they are detected, it is useful to form alliances or to purchase small-scale innovators outright. It is also important to map out explicitly whether small-scale activities in different parts of the value chain can provide a competitive advantage. Large retail companies like Tesco and Wal-Mart as well as manufacturers like PPG have benefited by re-examining the size of their typical “interface” with their customers while still maintaining scale elsewhere in the value chain. When looking internally, companies should also review their existing smaller operations to see if they are obtaining the benefits that may be there for the taking. Automobile plants in South Africa, for example, were built not in order to develop managerial talent but to bypass import duties in that part of the world. By mining those operations for top managers, however, some auto companies have reaped a most valuable secondary benefit.

Developing small-scale operations has its challenges. One is the “indivisibility of labor” — an engineer can only be in one place at a time. Technology is breaking down this problem, however, by making it possible for companies to reduce labor costs by sharing engineering talent across multiple facilities. At the same time, technology itself often seems to dictate a large-scale strategy. Again, however, it is important to question the validity of such assumptions, which some companies that have built their success on rethinking scale do continuously. Nucor is now experimenting with even smaller facilities that directly cast molten steel into its final shape and thickness, bypassing the need for any rolling at all. That process would further reduce energy costs and the need for capital equipment. The company believes it will be able to run mills that are one-eighth the size of the current minimills; such small facilities could be colocated with large customers. Consciously exploring the implications of scale provides opportunities not only to identify radically new technologies but also to make better use of existing ones.

It sometimes seems that large-scale operations are dinosaurs of the industrial age, and that in the hyperlinked digital age, where flexibility and speed are the watchwords, small-scale approaches should always win out. The truth is more complex than that. Consider the suggestion that car dealers could become micro-factories, locally assembling vehicles to customer order.7 In our view, many factors (supply-chain efficiencies, sunk costs, liability issues and so on) indicate that the vast majority of automobiles will still be manufactured at large plants for the foreseeable future. In the auto industry and elsewhere, ideas about scale should be rethought within the constraints of existing realities, not completely overturned.

Small-scale operations are a means to an end, not an end in themselves. Building knowledge, getting closer to customers, developing talent and monitoring technological change are all important in their own right, but they will add value only if they become an explicit part of a company’s strategy. Leaders who put those goals on the strategy map will be able to make conscious choices to leverage small scale in their companies’ favor.