Economy of Scale + Innovation = Winner

People often wonder why companies like GM is in trouble today. Everyone has opinions, like not being innovative, not understand customers or even too arrogant to understand what is happening in the world.

Most of that is true but in my opinion, they didn’t have a choice, they are forced in to their situation because they are in the hardware manufacturing industry and they are the leader in economy of scale.

Typically, companies that succeed do so because they have advantage over competition. In many sectors, having a cost advantage dictates how they will dominate the market. Much of the cost advantage in hardware area is due to the the economy of scale. Let’s take GM, they were the leaders of the automobile industry for many years because they had the economy of scale and was able to dominate the market so others couldn’t match the performance/price ratio.

Same situation occurred in the chip industry. The leader of the microprocessor market is Intel, not because they produce better product but they spent more in foundries and technologies so they would always have economy of scale compared to, let’s say AMD. I never found Intel to be a great technology company, just superior manufacturing and possibly a good marketing company. However, the economy of scale affords them better margin, which turn in to more cash in hand, then can be invested in R&D for further economy of scale. It’s a perpetual cycle where the leader retains the lead because they can make things cheaper and compete better because they make more of the product.

Then, why did GM fall from the top and lost the leadership to Toyota when they had the advantage in economy of scale? It’s the diametrically opposing force, innovation, or more precisely, lack of innovation. For a small company, like most Silicon Valley startup companies producing hardware, they can’t compete in price so they have to compete in innovation. Being innovative means you have to take more chances and try unproven technologies to stay ahead of competition. There is a big risk of being innovative. These companies succeed only 10% of the time but those 10% have high growth potential, thus increasing their economy of scale. Then why weren’t GM innovative thus maintaining their lead?

The answer lies within the promise of economy of scale. The only way to achieve the economy of scale is through consistency and status quo. Let’s say GM had decided to use a brand new seat restraining system that has been unproven but potentially cheaper and saves more lives in a car crash. However, for GM, the cost savings and live savings do not justify the negatives from the risk it will be taking. First, the initial cost to bring up the new technology will be much higher than current seat belts. Second, the liability associated with the system is not well known and predictable. If these systems are not well tested, increased injury/death associated with the product will wipe out the economy of scale advantage and more. Lastly, typical GM attitude of NIH (Not Invented Here) prevents them from seeking outside assistance in innovation. The bottom line for them, innovation = high risk = possible higher cost.

However, several companies in high tech area have taken big risks and still enjoy the economy of scale, Intel being one and Dell used to be other. Dell fell in to the similar route as GM, they did not embraced the innovation because they focused on the manufacturing and cost reduction. However, in the rapidly changing world, they forgot to be innovative because changes posed risks and short term higher costs. Imagine if they decided to move from screws that was English measurements to Metric measurements. Even if the Metric screws were cheaper and more universal, they would have to change all the tooling, like screwdrivers, on manufacturing line to accommodate this small change. These costs a lot to Dell and adds risk of losing productivity while the conversion is going on. So, often the larger the company like Dell gets less innovative to reduce risks.

There are other exceptions to the rule. Apple is one of them. Using almost autocratic management style, where whatever Steve says goes, Apple is able to take large risks and succeed most of the time. They stay nimbler than most large companies and able to innovate. This is built in to the culture and there had a bit of luck on their side with right timing. Of course they had failures, like AppleTV, but they had more hits than duds, so they are doing better than most of the industry.

Others, including 3M and Sony, encourages employees to spend up to a certain percentage of their work time on something other than what’s on their job description. Both companies have won many innovation awards in the past and one of major reasons why they are/were the leaders of their sectors. 

The final examples are software companies. Since there is no hardware cost associated with building something, the economy of scale doesn’t work here. Innovation is the king in software companies. Google has such a high valuation because they are a software company without hardware disadvantages. Same with the Facebook. However, even in software companies must stay innovative to stay ahead. Google learned from 3M and Sony and allows their employees to work on their own pet project. Some of these innovative ideas became core products Google offers. Of course, they have it easier because they don’t have to deal with economy or scale in manufacturing.

The bottom line is, while it’s difficult to achieve, large hardware companies can sustain leadership with right mix of scale of economy and innovation.