The 80/20 Principle: The Secret of Achieving More With Less by Richard Koch Page B
Book: The 80/20 Principle: The Secret of Achieving More With Less by Richard Koch
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Authors: Richard Koch
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assembly line, multiplying the revenues of the average firm, creating mass branded consumer goods for the first time in history, slashing the real cost of those goods, and giving more and more power to the largest enterprises. Then there was the emergence of so-called multinational enterprises, which initially took the Americas and Europe, and later the whole world, as their canvas. Next came the conglomerates, a new breed of corporation that refused to confine itself to one line of business and rapidly spread its tentacles across many industrial sectors and a myriad of products. Then the invention and refinement of the hostile takeover, fuelled equally by management ambition and the financial lubrication of leverage, gave further impetus to size. Finally, in the last 30 years of the century, the determination of industrial leaders, mainly from Japan, to seize global leadership in their priority markets and as much market share as feasible provided the final reinforcement to the cult of corporate size.
For various reasons, therefore, the first 75 years of the twentieth century witnessed a progressive and apparently unstoppable expansion in the size of industrial enterprise and, until recently, in the proportion of business activity taken by the largest firms. But in the past two decades, the latter trend has suddenly, and dramatically, gone into reverse. In 1979, the Fortune 500 largest U.S. firms accounted for nearly 60 percent of U.S. gross national product, but by the early 1990s this had slumped to just 40 percent.
Does this mean that small is beautiful?
No. This is definitely the wrong answer. There is absolutely nothing wrong with the belief long held by business leaders and strategists that scale and market share are valuable. Extra scale gives greater volume over which to spread fixed costs, especially the overhead costs that make up the lion’s share of all costs (now that factories have been made so efficient). Market share, too, helps to raise prices. The most popular firm, that with the highest market share, the best reputation and brands, and the most loyal customers, should command a price premium over lower-share competitors.
Yet why is it that larger firms are losing market share to smaller firms? And why does it happen that in practice, as opposed to theory, the advantages of scale and market share fail to translate into higher profitability? Why is it that firms often see their sales mushroom yet their returns on sales and capital actually fall, rather than rise as the theory would predict?
The cost of complexity
The most important answer is the cost of complexity. The problem is not extra scale, but extra complexity.
Additional scale, without additional complexity, will always give lower unit costs. To deliver to one customer more of one product or service, provided that it is exactly the same, will always raise returns.
Yet additional scale is rarely just more of the same. Even if the customer is the same, the extra volume usually comes from adapting an existing product, providing a new product, and/or adding more service. This requires expensive overhead costs that are usually hidden, but always real. And if new customers are involved it is far worse. There are high initial costs in recruiting customers and they generally have different needs to existing customers, causing even greater complexity and cost.
Internal complexity has huge hidden costs
When new business is different from existing business, even if it is only slightly different, costs tend to go up, not just pro rata with the volume increase but well ahead of it. This is because complexity slows down simple systems and requires the intervention of managers to deal with the new requirements. The cost of stopping and starting again, of communication (and miscommunication) between extra people and above all the cost of the “gaps” between people, when partially completed work is set down to await someone else’s
For various reasons, therefore, the first 75 years of the twentieth century witnessed a progressive and apparently unstoppable expansion in the size of industrial enterprise and, until recently, in the proportion of business activity taken by the largest firms. But in the past two decades, the latter trend has suddenly, and dramatically, gone into reverse. In 1979, the Fortune 500 largest U.S. firms accounted for nearly 60 percent of U.S. gross national product, but by the early 1990s this had slumped to just 40 percent.
Does this mean that small is beautiful?
No. This is definitely the wrong answer. There is absolutely nothing wrong with the belief long held by business leaders and strategists that scale and market share are valuable. Extra scale gives greater volume over which to spread fixed costs, especially the overhead costs that make up the lion’s share of all costs (now that factories have been made so efficient). Market share, too, helps to raise prices. The most popular firm, that with the highest market share, the best reputation and brands, and the most loyal customers, should command a price premium over lower-share competitors.
Yet why is it that larger firms are losing market share to smaller firms? And why does it happen that in practice, as opposed to theory, the advantages of scale and market share fail to translate into higher profitability? Why is it that firms often see their sales mushroom yet their returns on sales and capital actually fall, rather than rise as the theory would predict?
The cost of complexity
The most important answer is the cost of complexity. The problem is not extra scale, but extra complexity.
Additional scale, without additional complexity, will always give lower unit costs. To deliver to one customer more of one product or service, provided that it is exactly the same, will always raise returns.
Yet additional scale is rarely just more of the same. Even if the customer is the same, the extra volume usually comes from adapting an existing product, providing a new product, and/or adding more service. This requires expensive overhead costs that are usually hidden, but always real. And if new customers are involved it is far worse. There are high initial costs in recruiting customers and they generally have different needs to existing customers, causing even greater complexity and cost.
Internal complexity has huge hidden costs
When new business is different from existing business, even if it is only slightly different, costs tend to go up, not just pro rata with the volume increase but well ahead of it. This is because complexity slows down simple systems and requires the intervention of managers to deal with the new requirements. The cost of stopping and starting again, of communication (and miscommunication) between extra people and above all the cost of the “gaps” between people, when partially completed work is set down to await someone else’s
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