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Biggest Is Not Best

By Steven Pearlstein
Friday, January 18, 2008

We've been hearing it for years from corporate executives, management consultants and industry analysts: To survive in highly competitive markets, you either have to be big enough to have scale or small enough to find cover in protected niches. In between is a competitive no man's land where no company can make it.

There's some truth to this conventional wisdom. Bigger companies enjoy all sorts of economies of scale that give them a big cost advantage over smaller rivals. They also have easier access to capital and the wherewithal to ride out the inevitable hard times. So it's no surprise that most of the mid-sized firms and regional chains that we once knew as customers, suppliers or employees have either been forced to close their doors or gobbled up by the national and international giants.

What may also be true -- and what I'd like to suggest here -- is that the focus on size has been taken too far, that there's been too much mindless consolidation and growth-for-growth's sake.

Much of the blame for this falls on Wall Street, whose investment bankers are constantly knocking on doors of executive suites with proposals for mergers and acquisitions that earn them huge fees, whether the deals eventually work out or not. (Mostly they don't.) There are also the industry analysts and fund managers, who are addicted to double-digit earnings growth and punish companies that don't deliver it.

And let's not forget ego-driven corporate executives who like nothing more than to look at a competitor and think, "Mine is bigger than his."

But as the country slides into recession, we are going to discover that this absurd fixation on scale and growth has made many companies weaker rather than stronger. Newly acquired divisions will be shuttered, spun off and written down. And many more industry leaders are likely to follow Starbucks and Wal-Mart in slowing the pace of organic growth.

What companies in many industries are about to discover is that the competitive sweet spot may not be in being No. 1 or 2 in your category, as General Electric's Jack Welch once famously declared, but in being slightly back in the pack, where it's possible to deliver a more profitable trade-off between price and quality.

Think for a minute about what happens, particularly in the service sector, when companies get big. What do they do? They get more efficient. And how do they get more efficient? By coming up with sophisticated systems that allow them to produce consistent, predictable outcomes in everything they do while using as few and low-paid workers as possible.

In the restaurant business, for example, the big chains spend lots of time and money coming up with demographic and financial parameters for locating outlets. They hire executive chefs who whip up industrial-style recipes for menu items that they test on focus groups and can be replicated by line chefs with little experience and culinary flair. They come up with standard prototypes for how the restaurants will be laid out, how they'll be decorated and equipped, what plates, uniforms, napkins and menus they'll use. They purchase a computer system that not only takes care of processing meal orders and keeping track of the money and reordering food from the central warehouse, but also identifies any store or shift or employee producing results that are outside the desired norms. They even come up with the standard responses the hostesses and waiters use in greeting customers and handling complaints.

In the end, what you wind up with is a company that has a small corporate headquarters full of highly-paid people who design and refine these systems. At the restaurant level there are large numbers of low-skilled workers who are easily replaced and paid relatively low wages for essentially showing up and following the standard procedures. Together they create a giant company with lots of scale efficiencies producing a predictable product at a competitive price that appeals to large numbers of consumers.

With variations, of course, the same approach is now taken by hoteliers, airlines, insurance companies, retailers, banks and customer service centers. You see hints of it even in such supposedly creative fields as software development, accounting, journalism, medicine and the law.

There are two reasons, however, why I think this model won't dominate the future the way it has the recent past.

The first is that these companies are coming close to having saturated the U.S. market. There's not much more cost they can squeeze out, so they can't stimulate additional demand through price cuts. And as a result of their relentless expansion over the past two decades, there are no new regions to enter.

At the same time, I sense there's a growing backlash against these models from customers who are dissatisfied with formulaic products and lackluster service. This backlash has provided an opening for competitors offering something different and better, even if it is more expensive.

This is the challenge facing Starbucks and Wal-Mart. And it lies behind the recent success of former "niche" players such as Whole Foods, JetBlue, Coach and boutique hotels such as those run by the Kimpton Group. Indeed, these "middle-tier" companies are so focused on growth that, ironically, they have wound up adopting many of the same characteristics as the industry giants.

But the other reason I see an opening for mid-tier companies is that the good ones are better able to attract employees who have the creativity and initiative key to success in service industries. Those kinds of employees attach high value to autonomy and independence and don't work particularly well in organizations where regimentation is built into the corporate DNA. And because the focus at these companies isn't driving growth by driving down costs, they are able to offer more attractive compensation packages, particularly in the area of incentive pay.

You have already seen this phenomenon in advertising, finance and the law, where many of the brightest people are gravitating to boutique firms. And if I'm right, you are going to soon find it in mid-size retail chains that employ knowledgeable sales people rather than clueless clerks, and health insurers that assign a nurse practitioner with a name and phone number to every customer to handle everything from choosing a doctor to correcting a billing error.

Steven Pearlstein can be reached atpearlsteins@washpost.com.

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