How big should a company be?
76 years ago Ronald Coase set out to explain why people organize themselves into businesses, firms, and corporations rather than just freely trade goods and services with one another. If Adam Smith’s “invisible hand” is so efficient, why don’t we all organize ourselves independently?
The answer has to do with costs. It’s cheaper to build a firm around one product or service and aggregate the inputs and outputs needed to get the product to market, rather than everyone negotiating every little detail with everyone else. With a large and complex system like a car, there are literally millions of parts, each of which must be built to precise specifications. It would be really inefficient for the billions of transfers to be negotiated independently.
Transactions costs can be lowered dramatically by bringing them into a single firm. When this works, it works beautifully: an engaged workforce creates and produces something the sales-force can market effectively, gathering feedback from customers as they go, funneling this to an R&D group that solves problems imaginatively.
But nothing fails like success. Small firms that “ideate” effectively grow into behemoths that become caricatures of themselves: cubicle farms straight out of “Dilbert.” That’s partly why there’s so much investor skepticism around Apple or other fast-growers: no tree grows straight to heaven. Mega-firms create mega-administrative bloat and bureaucratic nonsense: a Soviet-style republic where meeting the plan and compliance are far more important than innovation and customer service.
Lincoln once answered the question, how long a man’s legs should be by quipping, “Long enough to reach the ground.” The answer to how large a firm should be is equally simple: large enough to be efficient—and no larger.
Douglas R. Tengdin, CFA
Chief Investment Officer