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What is the ideal firm size for your business?

It seems like an academic question. Everyone likes to think that they are unique. “Large numbers don’t apply to us,” but it’s a good idea to at least recognize the forces behind those large numbers.

Ideal firm size is the most competitive size of a company in a given industry at a given time. The long-run average cost curve suggests there is an output level where economies and diseconomies of scale even out and unit costs are at a minimum. Profit per unit would presumably be at maximum.

More likely than not, you compete in several lines of business, which may not align with a single six-digit NAICS code. Even if they do, there are no commonly accepted methods for measuring economies or diseconomies of scale.

Economies of scale are typically due to buying in bulk, managerial specialization, lower interest rates, and technology. Diseconomies of scale are less well understood, but two major forces are the increased cost of communication and the increased cost of management. Compounded by the need for oversight, the unintended effects of growth can give pause to even the most daring businessperson.

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Mfg. Productivity by Employment Size

If we compare revenue per employee to employment size, this should reflect economies or diseconomies of scale. With economies of scale, we would expect to see increased productivity. Manufacturing data suggests there are increasing returns to scale; meaning that with more input you would expect disproportional increases in output.

This confirms that advances in technology are the main driver behind the production function. Unfortunately, what is true for manufacturing in general may not be true for your specific industry or at least it doesn’t tell the whole story.

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Saw Blade Productivity by Employment Size

Saw blades and handsaws, for example, show a different picture. Rather than steadily increasing returns to scale, we see a roller coaster ride. Rapidly increasing and decreasing returns to scale lead back finally to increasing returns to scale.

What drives this pattern? If we look at payroll as a percentage of revenue, we see the slump in productivity matches the spike in payroll, not to be confused with labor content. This suggests that from the 20 to 99 employee level the increased cost of management outweighs the benefits of managerial specialization. That puts a real kink in the long-run average cost curve.

Payroll Percentage by Employment Size

Payroll Percentage by Employment Size

Where does that leave us? Be skeptical of combined data; it may not reflect your circumstances. Approach growth with caution; top-line growth doesn’t give you the whole picture. Small may be beautiful in your industry; let the private equity firms oversee the professional managers. Know your local cost structure; otherwise, you may not know the best mix of inputs or how best to compete in a global marketplace.

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