Determining the Best Size of Business Units: 5 Factors

The factors that determine the best size of the business units (the optimum size of the firm) are studied under the following five groups: 1. Technical Factors 2. Managerial Factors 3. Financial Factors 4. Marketing Factors 5. Factors of Risks and Fluctuations.

1. Technical Factors:

Technological factors underline the need for enlarging the scale and size of operations of a firm. Production processes are organised on large-scale and operated on specialized functional basis in order to realise to the full extent the technical advantages.

Working of machines with all their capital and operational cost will be economical and productive only if production is planned on a large scale. Plant, tools, equipment, etc. required for the engineering side of the productive operations will justify the heavy investments made therein only if they are utilised to their rated capacity.

Unutilised or idle capacity will mean higher burden of costs. Hence the firm has to increase the scale of its operations in order to spread the overhead costs over a large output. When more output is turned out with the fuller utilisation of technical avenues, the costs per unit would be lower.

Optimum technical unit emerges when the production reaches its zenith of technical capacity at the level of lowest average costs. “An increase in the size of firms,” says Beacham, “enables maximum advantage to be taken of specialisation and division of labour.”

Methods of Reaching towards Optimum Size:

A large-sized firm is in a position to reach towards the technical optimum mainly by the following methods:

(i) Division of Labour, and

(ii) Integration of Process.

(i) Division of Labour:

Division of labour or the principle of specialisation is a key to large-scale production. It means dividing the task into different processes or elements and assigning each process or element to a particular person instead of entrusting the entire task to one individual.

As Adam Smith illustrated, the pin-making jot is divided into 18 distinct operations and each operation is looked after by separate person. Shoe-making, automobiles, radio-sets, watches etc. pass through hundreds of hands specialising in only one aspect of the total operations. Division of labour increases the dexterity in workmanship, results in saving of time and leads to invention of machines, small or large, for replacing the manual work of man.

Robinson says, “it is by securing the steady concentration of man and machine upon a single task that the division of labour achieves economy and the large firm enjoys an advantage over the small firm in so far as it makes this concentration possible.”

A large firm can employ specialised personnel to handle the functionally designed and laid out plant and equipment. Division of labour paves the way for technical advances and “reduces or lightens the burdens of labour.” Mechanical operations in varied tasks are justifiable only when production is on sufficiently large scale so that additional capital costs are fully covered by the saving in labour costs.

A small firm cannot afford to install and operate large machine because that would mean heavier capital cost, higher interest charge, greater replacement costs as well as more recurring expenses on its specialised staff for operations and maintenance. Robinson, therefore, points out that a firm should be sufficiently large to obtain the maximum qualitative division of labour.

A large-sized firm can acquire large machines, keep them in operation to full capacity so that larger output can be turned out at lowest average cost through versatile technical methods.

(ii) Integration of Process:

Technical economies can also be realised by a large firm through integration of process. It means linking of processes and stages in production through devising large machines. Large machines take over the tasks being hitherto performed by different small machines and manual operations.

For example, operations of the production of pig iron, raw steel, semi-finished steel, steel castings and steel products connected with the stages of the production may be so organised that the entire process is completed in one continuous sweep by a large machine.

Two or three consecutive processes can be performed by a single machine thus eliminating labour required to set the work on different machines. It is only the large firm which can adapt expensive machinery for full scale operations.

Thus the technical optimum depends on:

(a) Use of machines to replace human efforts;

(b) Continuous use of machines upto the installed capacity and further expansion of the scale of production, if necessary;

(c) Larger output and reduced costs per unit;

(d) Integration of process by devising complicated multi-process machines; and

(e) Standardisation of products.

Limitations of Technical Factors:

But there is limit to the realisation of technical economies. Beyond that limit, further increase in the size may not lead to optimum results. Availability of capital, absorbability of market, inflexibility of large machines, changes in market trends etc. limit the technical gains after a particular stage.

Optimum technical unit is large in industries where the product and the productive machine is physically large, such as steel, ship-building. Optimum technical units are also high when the final product is of complex nature, for example, composite of many parts like automobiles, type writers, radio-sets, etc. Optimum technical units are smaller where the products are simple and small, for example, bakery, weaving of standard cloth, cutlery, stationery, simple powerloom in textiles, etc.

Small firms also can realise some of the technical economies by vertical disintegration which means carrying on specialised operations independently by separate firms. Nevertheless, large firms are in an advantageous position of economising the unit-wise costs by operations put their full capacity.

Robinson points out that technical considerations “place a premium on large-scale production.” The technical costs of production are likely to fall as more is produced up to a particular limit and thereafter may remain constant.

Hence the technical optimum provides a minimum scale of efficient operation and does not spell out precisely the maximum scale beyond which growth will lead to increasing tendency of costs per unit. Technical optimum can be enlarged only if other forces such as marketing, managerial and financial consideration are required to be balanced.

2. Managerial Factors:

The technical benefits of division of labour and integration of process can also be realised by larger firm in the sphere of management. The superior technology and the engineering side of an undertaking would be of no avail if the management is not competent, responsive and economical from the cost point of view.

The success of firm is not decided by the size of investments of assets acquired but is hinged on the managerial ability of men at the helm of affairs of the firm. The influence of management on the size of the undertaking can be analysed in terms of specialisation and integration.

Management is concerned with planning, organising, coordinating the activities and motivating and controlling the personnel specially drafted for various operations. A large firm can give functional bent to management. The large firm can divide the functions of management into many sections or departments.

Policy-making is the privilege of the Board of Directors. Execution of the policies is with the managing director. Division of labour is also introduced in the allocation of duties among the executive officers depending on their area of specialisation.

Financial operations, estimating and costing are separate from the manufacturing, marketing, purchasing functions. Experts are appointed to head the different sections or departments like production, purchases, sales, accounting, financing, record-keeping, correspondence, etc.

A large firm can get the services of splendid organiser, technical genius, financial wizard, industrial psychologist etc. and with their combined knowledge, experience and guidance, it will be possible to produce a better article, cheaper and more profitable than the small firms could have done independently.

Gains from Managerial Division of Labour:

Managerial division of labour confers certain gains on the large firm:

1. Through the Influence of Specialisation:

(a) Specialisation can be built into the varied delicate processes and tasks of management. Special talents can be given full scope for intelligent planning, skillful execution and masterly organisation. Qualified executives and experts will be freed from the routine matters, clerical details, etc. That can be handled by other staff of average abilities. Planning and executing are separated in a large firm leading towards prompt, accurate and better work.

(b) There will not be overloading of duties and hence each will be able to give concentrated attention on the job assigned to him and develop his faculties and talents to the fullest extent.

(c) The workers and the subordinate staff in a large firm can carry out the work without interruptions because the higher levels of management will have formulated master plan and operational plans to direct the course of the job and will have made arrangements for tools, materials, etc. necessary for performing the job.

(d) A large firm can expand its activities without perceptible difficulty if it has already a competent cadre of experts, accomplished executives and administrative officers. The costs of management will not increase unit-wise as the firm goes on expanding its scale of operations. If more officers are to be appointed, additional expenses thereof would be more than covered by additional efficiency in business planning and performance.

“A large firm”, says Robinson, “can obtain an economy because certain services do not have to be increased in the same ratio as the growth of the firm or if increased in the same ratio are much more efficient.”

Thus from the point of cost, a well-managed large firm with a complement of expert, experienced and trained officers will be more economical than a small firm with lower management expenses. A small firm cannot afford to maintain an expensive administrative staff.

A large firm can fully utilise their talents for better planning and profitable performance of jobs. The higher costs of management, according to Robinson, are offset by the lower costs of the actual productive departments due to the efficiency of the management.

2. Through the Influence of Integration:

On the managerial side also, integration of processes can be thought of to some extent to economise costs and enhance efficiency. On the technical side, large multi-purpose machines handle the ‘complex’ of many operational processes.

On the management side, however, man counts more than the machine. Human ability, calibre, skill are more significant in managing a firm. But now a days, machines have crept into administrative channels and have replaced quickly a few tasks which were being hitherto handled by the human efforts.

Office appliances, typewriter, dictating machines, accounting machines, address-graphs, calculating machines, etc. have made the work more accurate, quick and reduced the drudgery of clerical routine.

Even the intellectual aspects of administration, planning, policy-making etc. are being tackled by computers, cybernetic devices. Automation, robot systems represent the integration of administrative processes.

The devices can be employed only by a large firm.

Thus optimum managerial unit is attained by:

(a) Functional arrangement of activities and allocation of tasks to respective specialists;

(b) Expansion of business operation on a scale sufficient to make fuller and continuous use of the services of experts and executives in the management hierarchy;

(c) Increase in the efficiency so as to spread over the higher cost of top and expert management on larger and better output; and

(d) Adoption of time-saving mechanical appliances to aid in the performance of managerial or administrative functions.

Limitations of Managerial Factors:

But the managerial optimum is subject to following limitations:

(i) Extreme specialisation may prove to be expensive and unprofitable.

(ii) Effectiveness of specialisation depends on the degree to which the management can bring about coordination between the working of different departments into which the firm’s activities are grouped. Benefits of division of labour should outweigh the cost of centralised administrative set-up to coordinate the plans and actions of different departmental experts and executives.

(iii) A large firm with elaborate managerial processes may become a victim of bureaucracy and red-tapism which would neutralise the benefits of specialisation.

(iv) In a large firm the management may not be able to develop intimate public contact which is essential for the success of a firm’s business.

3. Financial Factors:

Financial factors influence the size of the firm through the rates of interest at which it can borrow and the amounts which they can obtain at a given rate. Depending on the circumstances, a firm may sometimes borrow small amounts at a favourable rate of interest or at other times borrow small amounts less favourable (more interest) rate but larger amounts at more favourable (lower interest) rate.

The conditions in the capital market, business record of the firm, it’s likely prospects, the nature of industry, the profits it has earned, etc. determine the ability of the firms to raise funds required by them.

Small firms including sole proprietorships are not able to mobilize sufficient funds for expanding their business. Large firms, particularly joint-stock companies with limited liability have been able to build up their business by the proceeds of public issue of shares and debentures.

The growth of sole traders, partnership firms and private limited companies is hampered by their relatively lesser capacity to raise the financial resources whereas public limited companies have wider scope for mobilising capital in forms of different types of shares and debentures subscribed to by the public. In raising the capital by public subscriptions, large firm has an advantage because of its high standing and reputation amongst the investing public.

Large firm may build up its financial strength by adequate reserves. Small firms may lapse into instability if they have no sufficient reserves to face any contingency. Large firms have better staying capacity in times of depression and emergency. In a large firm it is possible to plough back a portion of divisible profits to finance new ventures or expansion.

A large firm with multiple product or services will find it convenient to finance one aspect of its activities by another. Large firms can borrow easily, readily and on competitive rates from banks to meet their short-term needs of working capital.

Banks prefer large firms as their loanee-customers because their size gives an impression of solidarity and security. Banks hesitate to finance small firms on adequate scale. Financial factors inhibit the growth of small firms while they provide incentive for a large firm to expand still further.

As Beacham said small firms often die inspite of their technical efficiency and fair long-term prospects because they cannot be financed over the difficult developing period.

Thus on financial side also large firms have their dominant position. While they can raise the capital or borrow funds whenever required, it should be ensured that the funds are profitably employed for conducting the business on suitable scale. Otherwise large firms have to face the burden of interest rates and repayment schedule if funds remain idle or if they are not fruitfully employed.

Financial optimum is attained by a large firm in the following ways:

(a) By accurate financial planning, determining the short-term and long-term capital requirements on the basis of existing state of business and expected changes therein;

(b) By avoiding over-capitalisation and under-capitalisation so that capital raised is represented by equivalent value of productive assets;

(c) By selecting the proper timing and method of issuing shares, debentures etc. so that more funds can be raised at economical rates;

(d) By making adequate provision for contingencies, depreciation, bad debts etc., repayment of old loans, periodical payment of interest on loans raised, etc.; and

(e) By adopting budgetary control, accounting and auditing to ensure proper use of funds and preventing misappropriation.

4. Marketing Factors:

Marketing factors influence decisively the size of the firm and the scale of operations. The economies of scale are clearly marked in the marketing processes of a large firm. From the point of cost factor, optimum point in respect of marketing operations is attained by a firm through the conduct of its marketing operations on sufficiently large scale consistent with its production and sales potential. Marketing has two facets-buying and selling.

A firm has to buy carefully the required raw materials, stores, tools etc. in time and in proper bulk so that production process continues unhampered.

The quality of the final product depends to a large extent on the quality of materials used in its manufacture. The price of the final product also is determined in major part by the cost of materials bought.

Adequate and timely purchase of materials at economical prices will be a necessary condition for the schedule-wise manufacture of goods and their scale in the market. Hence buying influences the size of a firm. Need for economical buying creates tendency towards the increasing size of the firm.

Advantages of Large-Scale Buying:

1. A large firm can buy bulk of commodities in a single order or deal. Sufficient stock of materials can be built up by a large firm so that manufacturing will proceed unhindered. A small firm is not in a position to buy large stocks of materials at a time and hence it is more likely to run short of the materials as compared to a larger firm.

2. Through its bulk purchases, a large firm can bargain with the seller and obtain the supplies at cheaper rates as higher rates of discounts on larger volume of purchases are offered by sellers.

3. Large firm being one of the dominant customers of raw materials suppliers can secure continuous supplies and other concessions in packing, forwarding charges, terms of payment, etc.

4. A large firm has strong bargaining power. In the words of Robinson “the seller will be driven to quote his lowest price rather than ‘take it or leave it price’ which he may quote to other smaller undertakings. The large firm, is then in a stronger bargaining position as against its suppliers than the small firm.” Small firms are forced to buy in small lots while large ones can compel the sellers to quote economical or cheaper rates and terms because they can afford to buy in bigger lots.

5. A large firm can realise economies in transport, handling and storage expenses because of the bulk purchases.

The large firm however will have to suffer hard if there is slight error in the judgement of experts. Small firms can readily correct the errors in purchases while large firm finds it impossible to correct an error without affecting market trends.

Small firms however can get over the disadvantages of limited buying and seek to realise the economies of large-scale buying through vertical integration by common agreements, using facilities of produce exchanges, etc.

But such common agreement for collective buying will not be practicable all the times and small firms also may not be in a position to get facilities of organised markets in respect of all types of raw materials. Hence large-scale buying is by and large more economical.

Economies of Large-Scale Selling:

Selling is obviously the most critical aspect of a firm’s working. The quantum of sales, the rate of sales turnover, wider coverage of market, selling expensive etc. exert far-reaching influence on the size of the firm. More and quicker sales, highest possible prices and minimum costs of selling are the aims of every firm.

Large-sized firm has certainly advantages of wider sales and spreading over of selling expenses these are as follows:

(a) Large firm may produce sufficient output and keep adequate stocks for continued inflow into the market. Demand goes on varying from time to time. Large firm can adjust its production schedule and stock positions according to the changes in the level of demand.

(b) A large firm can, through adequate reserve stocks and ready productive capacity, meet any emergency demand for goods.

(c) A large manufacturing firm or a bigger trader can afford to carry a large variety of stocks and “attract customers by the wider range of choice offered. A large firm can expand in different lines and offer wider choice of variety of goods.” This induces larger orders from larger number of customers.

(d) A large firm can extend the tentacles of its selling to even foreign markets.

(e) Large firms can carry on extensive advertising campaigns to create, promote or expand sales of their products in different markets. Large firms have the capacity to spend sufficiently on advertising and other sales-promotion efforts. Moreover, since their scale of selling is wider, the higher advertising expenses are spread over their total sales. Thus expenses on advertisement etc. per unit of sale is less as more and more units are sold.

Small firms either cannot afford to spend on advertisement, etc. or even if they spend, their selling expenses will be burdensome since their total turnover is limited in quantity and velocity.

(f) A large firm can maintain its selling organisation to promote sales. Where the scale of selling is not large, elaborate sales organisation is expensive to maintain. Capacity of the sales staff is fully utilised by a large firm operating its sales on wider scale. In a smaller firm the abilities of salesman may not be fully utilised because of the limited turnover.

Large firms can also think of vertical integration by having their own distribution system. They may set up their own sales depots, distribution centres, emporia, etc. and approach the customers more quickly and extensively. Thus marketing optimum is attained by a large firm through organising its buying and selling operations on large scale.

The marketing optimum depends on the extent to which a firm can buy in bulk at cheap rats and sell in bulk with least selling expenses.

5. Factors of Risks and Fluctuations

Risks and uncertainties are the part and parcel of industrial organisation. Firms have to face fluctuations in demand for their products and accordingly adjust their policies and strategies in order to survive and maintain their position in the market. Risks of changes in demand have their impact on the trends in the size of firms.

The firms should have the necessary strength to absorb the shocks of fluctuations in demand and they should be flexible enough to adapt to new trends in demand. Size of a firm should be such as to enable the firm to ‘stay on’ despite the rough tides of fluctuations, at the same time the bulkiness of its size should not hinder its adjustability and adaptability to new trends in the market.

Variations in Demand:

(a) Permanent change in demand may occur due to decline in the popularity of a product or appearance of a direct substitute. It may also be caused by changes in fashion, tastes, technology or methods of production, so that the product a firm was so far producing becomes out of date and hence unsaleable. The firms engaged in production of such goods have to reorganise their production structure to cater to the changed demand and adopt new technology.

If the firm has versatile machinery capable of producing alternate models of articles, then adjustments would be easier. But if the machines are rigidly specialised, then permanent changes in demand would involve heavy cost of reorganisation. Old machinery has to be scrapped and new plant and machinery have to be installed.

Hence where industry is subject to fluctuations in demand because of changes in demand or in technology, “that firm is the strongest which can best face the problems of reorganisation and adaptation.”

If the firm is large with its elaborate technical equipment, the adjustment to new situation, re-equipment and reorganisation would be dilatory and expensive. Small firms can easily adjust to new demand pattern without much dislocation.

Large firms should foresee the possible changes in tastes and fashions and undertake timely measures to switch on to new products or models while the old ones are at the height of popularity.

(b) Cyclical variations in demand mean imbalance in demand and supply for a short period. Trade cycles involving alternative phases of boom and depression are common phenomena in the economic structure based on free enterprise system.

During depression, demand declines and there is glut of goods or unsold stocks pile up. Prices sharply decline and the firms find their revenue dwindling. Small and weak firms with meagre reserves are hard hit by depression and many of them may be closed down.

Large firms can pull through the depression period. But if they are compelled by circumstances to curtail their output, they are at a disadvantage because costs per unit increase due to shortfall in capacity-utilisation. Trade cycles many a time lead to amalgamation of firms so as to face the impact in concerted manner. Thus increases the size of the business unit.

(c) Seasonable variations, i. e. seasonal, changes in demand for certain products, for example, higher demand for woollen goods in winter. Off season slackness in demand is matched by firm providing for production of different products.

Another product may be designed and developed to be manufactured in combination with seasonally demanded product. The demand for the new product may also be seasonal but their seasonal periods are different, for example, summer and winter clothes may be produced at the same time.

A non-seasonal product may be dovetailed with production of seasonal product. For example, those engaged in farming during the harvest season in Switzerland take up watch-making in winter.

(d) Erratic variations in demand, i.e., irregular fluctuations in the quantity demanded occur in industries where products are not manufactured according to standardised pattern but where products are turned out as per individual orders and designs at different prices. For example, shop sign boards, special furniture, jewellery, visiting card, etc. are irregularly produced as per the ad hoc demand.

Thus there are problems of idle capacity of firms engaged in production of such goods during the intermittent periods when there is no demand.

To reduce the burden of overhead costs, such firm can go in for production of continuously demanded product. The profits are earned mainly by the sale of the main product as per special demand while the secondary products may be manufactured merely to cover the costs of production and keep the factors engaged.

According to Robinson, “it is common to combine the manufacture of some irregularly produced specialty with the manufacture of some standardised secondary product.” Sometimes secondary products are produced intermittently whenever workers are momentarily free from producing the main product.

It can be concluded that existence of risks does not favour larger size of the firm. Only when individual units seek to act in concert for reducing the intensity of adverse effects of permanent and cyclical variations in demand, there may be tendency toward larger size. Where monopolies are intended to be formed to face the risks, there would come into existence units of larger size.

But since we are viewing the firms operating under normal competitive conditions, we can conclude that risks and fluctuations in respect of demand favour small firms as they can adjust with least costs and dislocation.