Size matters: Should you go big or stay small

By J. Tol Broome Jr.

It seems to be the way we’re wired: If we own a 42–inch flat–screen television set, we want a 47–inch one. Why order the 8–ounce steak when the restaurant offers one that weighs in at 10 ounces? The 20–foot boat should be traded in for a 24–footer at the first opportunity. A business with $1 million in annual sales must hit $1.1 million next year. After all, bigger is always better. Isn’t it?

The entrepreneurial spirit behind most small businesses leads owners to want to grow their ventures. But getting larger and larger isn’t always the best strategy.

Just ask management guru and author Charles Handy.

“Americans think big. This has helped make them the most powerful nation on Earth, but bigger is not always better, either for our bodies or, I suggest, for our organizations,” Handy said in a 2008 interview on American Public Radio’s “Marketplace” business news program.

“Why does almost every business that I know seek to grow in size, year after year, in fact, as if there were no limit?” Handy continued. “Humans are most comfortable in clusters of 10 to 12—family–sized groups. Put them in armies of hundreds and thousands and they cease to be individuals…just numbers in jobs. Humanity too easily yields place to bureaucracy.”

Does Handy have a point? It depends on what you want your business to be. To figure out the best strategy for your business, consider the advantage of both getting larger and staying smaller.

Why BIGGER is better

Greater profit potential From an absolute dollar perspective, the bigger a business becomes, the greater the profit potential. If your business generates a net profit of $75,000 on annual sales of $500,000, then conceivably you can make $150,000 in profit on sales of $1 million, if margins stay the same. It should be noted that growth comes with a downside when times get tough. As a company grows, so do fixed expenses, making it more difficult to adjust when an economic downturn or recession hits.

Economies of scale A bigger company generally is better able to leverage fixed expenses. For instance, professionals such as attorneys and accountants don’t charge you double just because you have two warehouses instead of one. Economies of scale also can help you negotiate better deals from suppliers. The more you buy, the more likely you are to get a better per–unit price. The result is that economies of scale often will improve your relative bottom line as you grow. Again turning to the example of a business that earns $75,000 on $500,000: An enhanced profit margin due to better efficiency could result in $200,000 in profit on sales of $1 million.

Management depth Most small businesses are very reliant on the owner to work long hours to make the operation run smoothly and this can lead to high burnout rates. As a business grows, an owner is able to hire additional people to take on some of the management burden. Not only can this reduce the stress, it can bring in new ideas to improve products, marketing or operations.

uccess breeds success Management guru Peter Drucker said that the purpose of any business is to create a customer. As a business grows, it creates more customers, which leads to even more customers. Expanding your business by adding facilities, increasing advertising or expanding lines brings in more customers, who will, in turn, tell more prospective customers about your business. This increases revenues—and profits—without much effort on your part. One danger of keeping a business small is that it can stagnate, which can lead to a shrinking customer base and eventually failure.

More attractive when it’s time to sell It’s generally true that the bigger the business, the higher the potential sales price. There are two reasons for this. First, most businesses sell based on a multiple of cash flow. A bigger business is likely to have higher cash flow. For example, a business with an annual cash flow of $100,000 would sell for $400,000 at a 4x multiple while a business with a $200,000 annual cash flow would sell for $800,000 at the same multiple. Second, bigger businesses often bring even larger multiples because of other advantages I’ve already discussed (economies of scale, management depth, etc.). So if the business with a $200,000 annual cash flow could attract a multiple of 5x, the sale price could jump to $1 million.

The good side of SMALL

Easier to manage While a small business often is highly dependent on the owner for critical tasks, many owners prefer it this way. They know what it takes to manufacture high–quality products, generate sales, provide good customer service and do the myriad other tasks required to keep the doors open. And they like doing it all. Small companies have fewer employees, which typically means fewer personnel–related headaches. For instance, a business with 10 employees might go a year or more without any turnover. A venture with 100–plus employees is likely to be in constant hiring mode.

Less leverage A small business generally can be run with less or even no leverage compared to a larger venture. Less leverage makes a business more nimble and better able to weather disruptions in cash flow. The leverage issue often moves front and center when a business owner considers expanding and needs to borrow money to do so. While borrowing money is a traditional, practical way of expanding, some small business owners don’t want to take on the stress of accumulating debt.

Less risk I cited as an advantage of being a big business that larger companies generally make higher profits, but larger businesses also take on more risk. If you run a stable small business that generates an adequate profit to provide for your family and employees on a consistent basis, you might not want to risk the extra expense and debt that it can take to expand your facilities or add workers.

Tighter expense control As a business grows, it becomes more challenging to maintain control over expenses. Tasks must be delegated to employees, who may not share the owner’s mentality about spending company money. This can result in wasteful spending on everything from office supplies to travel to inventory. If you keep your business small, you’re more likely to keep tabs on every dollar that goes out the door.

Easier to cross–train A smaller business with fewer employees often enjoys more employee loyalty—some workers are likely to be family members. This loyalty and commitment allows you to more easily cross–train employees to be competent at multiple tasks. A business with 100 or more employees will have fewer opportunities to cross–train, which can result in idle time and inefficiency.

So, while bigger might be better when it comes to TVs and boats, the optimal size of your business is a matter of preference. Weigh these considerations to determine the best growth—or no–growth—strategy for your company.

J. Tol Broome Jr. has spent nearly 30 years working in commercial lending at various financial institutions and currently is an executive vice president and manager of the Specialized Lending Group at BB&T.
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Please link to this page: Determine the Right Growth Strategy for Your Company.

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