Firms

Classification of firms
Firms can be classified into:
1. Primary, secondary and tertiary sectors
2. Private and public sector, and
3. Large and small firms (using relative size of firms).
Primary, secondary and tertiary sectors of industry
• Primary sector - this contains firms that extract raw materials from the Earth (e.g. farming, fishing
and mining).
• Secondary sector - this contains firms that manufacture goods, that is, change raw materials into
finished products and construct buildings, roads and bridges.
• Tertiary sector - this contains firms that provide services to the general public and other firms (such
as retail shops, doctors, demists, schools, hairdressers, advertising agencies, lawyers, financial
advisers, insurance companies and banks.
Private and public sector
The term public sector includes all businesses owned by the state and local government such as; public
services, hospitals, schools and the fire services. Public sector firms aim to provide goods and services
people need at affordable prices
The term private sector includes all businesses owned by individuals, such as sole traders,
partnerships, limited companies and cooperatives. The aim of production for most private sector firms
is to make as much profit as possible
Small firms
The advantages and disadvantages of small firms, the challenges facing small firms and reasons for
their existence.
Advantages of small firms
• Flexibility. Small firms can adapt readily to consumer needs, designing products to meet individual
requirements, whilst some products cannot be mass produced.
• Industrial relations. The boss of the small firms tends to have a wide general knowledge of the
performance of their employees, and may have a friendly relationship. This could increase morale
and motivation. There is also less chance of poor productivity as there are less people in small
firms.
• Customer relations. Likewise, small firms are more likely to know their customers and to be able
to offer personalized services to their customers. Personal attention is more feasible in small
businesses, such as private music/sports tuition.
• Local monopoly. Some firms supply only to a small market, and specialist businesses are not
interested in these markets.
Disadvantages of small firms/ challenges facing small firms
• Difficulty in marketing products- due to lack of finance required for proper marketing of products
• Limited products, the product range is narrow which increases the risks of business failure
• Difficulty in obtaining finance- this is due to lack of collateral
• Difficult to compete with large firms due to absence of economies of scale
• Limited scope for economies of scale, this is due to small scale operations
• Lack of skilled labour-small firms cannot attract workers due to lack of finance
• Low sales / profits due to small scale operations

Why do some firms remain small? Reasons for existence of small firms
• Close supervision. When production is being carried on a small scale, the producer can easily
supervise each part of the work. The raw material is fully utilized by avoiding the waste. As the
workers are closely supervised, they work efficiently. The machines are carefully handled. All this
results in lowering of cost production.
• Economic independence. In a small firm, the producer is generally the sole proprietor himself.
When he clearly knows that the whole profit will go to him and not to anybody else, he works
harder.
• Easy to manage, a large firm has to spend a sizeable portion of the income on maintaining
administrative structures but that is not the case with the small firm. In a small firm, the proprietor
himself is the manager. He does not need complex account keeping. He just writes the income
and expenditure of his business on a small notebook and keeps that with himself.
• Close contact with customers. As the, workers employed in a small firm are few in number, the
employer can have a close contact with them. He can listen to their grievances personally and can
redress them if he thinks them justified. Due to better understanding between the and the
employees, the chances of industrial disputes are reduced.
• Greater adaptability to changes. Another advantage claimed by a small firm is that it can easily
adjust its supply to the changed conditions in demand. As the small firm has not to consult the
various shareholders of the business, so it can easily arrive at quick decisions and these decisions
can be promptly executed.
• New technology has reduced scale of production needed – this has made it easier for small firms
to get access to modern equipment and internet allows firms to reach suppliers and customers
worldwide
• Limited access to capital – small firms find it difficult to get loans from banks as they can’t
compete with larger firms
• A small market – if there is only a small number of customers there is no point in expansion
• Personal Preference – expansion can be time consuming and stressful or require more skills
Size of firms.
It may be the objective of a firm to increase its market share or to operate in several countries, and it
will therefore put strategies in place to achieve these aims. Alternatively, a business may choose to
stay small, such as a wedding dress designer, a hairdresser or an owner of a small gift shop. The size
of a firm can be measured in the following ways:
• The number of employees - In 2013, Glaxo Smith Kline, a large pharmaceutical company, had over
100000 employees. A small local grocery shop may have only five employees.
• The size of the market (market share) - For example, Hertz, Enterprise and Budget car hire
companies collectively had 95 per cent of the car hire market in the USA in 2013. Nestle dominates
the food and beverages market in Pakistan, as it is the leading company in milk production and related
products including yogurt, milk powder and butter. It also dominates the bottled water market in
Pakistan.
• The capital employed in a firm - This is the difference between the assets of a firm (what it owns)
and its liabilities (what it owes). For example, in January 2013 Walman's capital employed was $203.1
billion, making it the world's largest retailer.
• The sales turnover (sales revenue) of the firm. This is measured by multiplying the unit price of a
product by the quantity sold. For example, in 2012 Exxon Mobil had sales turnover of $433.5 billion
and was the world's largest firm by this measure.

How do firms grow?

1. Internal growth (organic growth)

• Firms can grow by increasing the number of branches (stores) within a particular country or by
opening branches in different countries. They can also expand by selling their products in a greater
number of countries and can finance this expansion using profits earned within the business. Coca-
Cola now sells its cola drink in all but two countries in the world: North Korea and Cuba.

• Firms can grow by franchising. This means that an individual or a firm purchases a licence from
another firm to trade using the name of the parent company. The Subway sandwich chain, established
in the USA, has approximately 141 stores in the United Arab Emirates (UAE) and this expansion is due
to franchising.

• Firms may attract investment from larger businesses. For example, the sandwich chain Pret a
Manger funded its expansion through investment in the company by the fast-food giant McDonald's.
Innocent, originally a small UK-based fresh fruit juice and smoothie manufacturer, is now large enough
to supply supermarkets in the UK and some overseas shops through investment funding from Coca-
Cola, which owns 90 per cent of the drinks company.

2. External growth (inorganic growth)

• Takeovers - A firm can instantly increase its size by buying a majority stake (share) in another
business. For example, the Indian car-maker Tata Motors took over the UK-owned Jaguar and Land
Rover in 2008. Microsoft bought Skype in 2011 and the purchase enabled the software giant to gain
a larger share of the internet communications industry. Take overs can be hostile, which means that
the firm being taken over does not agree to the buyout. Takeovers can also be agreeable to both firms.

• Mergers - Two firms can join together to form one new company. For example, the MTRC and KCRC
railway companies in Hong Kong merged in 2007 to become one company, which now is the only
provider of railway and underground railways services in Hong Kong.
Types of integration

Integration refers to the combining of two or more firms, either through a merger or a takeover.
Integration is concerned with the direction of growth

a. Horizontal integration

Horizontal integration occurs when two firms in the same sector of industry join together, by either
a merger or a takeover. Examples

The two combined businesses can benefit from:

• operating with fewer employees (as there is no need to hire two finance departments, for example),
so this may reduce costs
• gaining skilled employees from one another
• taking advantage of economies of scale.
• getting an increased market share
However, the potential costs or drawbacks include the following:
• There may be duplication of resources and therefore some workers may be made redundant - that
is, lose their jobs. Redundancies can cause anxiety, lead to demotivated staff and cause a decrease in
productivity.
• The combined firm may suffer from a culture clash if the two businesses are very different. This may
initially cause communication and organisational problems.
• The newly formed larger firm may face increasing costs arising from diseconomies of scale

b. Vertical integration
Vertical integration occurs when a firm from one sector of industry merges with, or is taken over by,
a firm from another sector of industry. There are two types of vertical integration: backward and
forward.
(i) Backward vertical integration occurs when a firm from the secondary sector of industry merges
with a firm from the primary sector, or a firm from the tertiary sector merges with a firm from the
secondary sector for example, if McDonald's buys a chicken farm.
Benefits of backward vertical integration
• The firm in the secondary sector has control over the quality of raw materials with which it is
supplied.
• There is no wastage as all produce from the primary sector can be used.
• The price of raw materials falls as the manufacturer does not have to pay another external firm for
the raw materials.
Disadvantages of backward vertical integration
• Costs of running the acquired firm increase total costs as more resources are required.
• Transport costs increase for the integrated firm as raw materials were previously delivered by
external suppliers.
(ii) Forward vertical integration occurs when a firm from the primary sector of industry joins with a
firm from the secondary sector, or a firm from the secondary sector joins with a firm from the tertiary
sector. For example, Apple, Levi's and Replay all own shops in which to sell their manufactured
products. Shell, the global oil company, owns its entire chain of production: oil mines, oil processing
plants and the petrol stations where consumers purchase fuel for their cars.

c. Conglomerate integration
Conglomerate integration (also known as lateral integration or diversification) occurs when firms from
different sectors of industry, which operate in unrelated areas of business, merge or are taken over
by another firm. They may form a single company or be part of a large group of companies. For
example, if a clothing manufacturer merges with a chocolate producer, the two firms are in the
secondary sector of industry but operate in different areas of manufacturing. They can take advantage
of risk-bearing economies of scale, as diversification spreads risk.

Economies of scale

One meaning of the word 'economy' is reduced expenditure or saving, while the word 'scale' refers
to size. Therefore, the phrase 'economies of scale' means that average costs of production fall as a
firm grows or increases output. Economies of scale are benefits of large-scale operations.

Internal economies of scale

Internal economies of scale are cost savings that arise from growth of a business.

• Purchasing or bulk-buying economies of scale occur when the cost of raw materials falls as they are
bought in large quantities.

• Technical economics of scale occur as large firms can afford to purchase expensive pieces of
machinery and automated equipment for the manufacturing process. Large firms also produce in large
quantities and therefore the high initial cost of the equipment can be spread across the high quantity
of goods produced.

• Financial economies of scale occur as large firms are able to borrow money from banks more easily
than small firms because they are perceived to be less risky to financial institutions. A large firm will
also have a greater number of assets that can act as security for a loan.

•Managerial economies of scale occur as large firms have the resources to employ specialists to
undertake functions within the firm: for example, accountants, engineers and human resources
specialists. High salaries paid by large firms will attract experts.

• Risk-bearing economies of scale occur as large firms rend to produce a range of products and operate
in many locations. This diversity spreads risks as weak sales in one country can be supported by strong
sales in another. Samsung makes a range of products and if one product is experiencing decreasing
sales then this loss can be balanced by increased sales of another product.

• Research and development economies of scale occur as large firms may be able to fund research
and development, and therefore can be innovative and create products that enable them to be leaders
in their area of business. For example, Glaxo Smith Kline is a large pharmaceutical company that
invests heavily in research and development (R&D), spending around 15 per cent of its sales revenue
(or around $6.26 billion) on it.

• Marketing economies of scale occur as big firms tend to have a large advertising budget and
therefore can spend large amounts of money on promoting their products. For example, a Nike or
IKEA advert exposes all products under the Nike brand and all products sold in IKEA in a cost-effective
way.

External economies of scale

External economies of scale benefits that arise due to growth of an industry to which a firm belongs.
External economies also arise from location of a firm. Examples of external economies of scale are:
• Proximity to related firms - Tirupur in India is renowned for textile and garment manufacturing. A
garment manufacturer will benefit from having firms that produce zippers, buttons, thread and fabrics
located nearby, as this will give it easy access to its suppliers and reduce transport costs.

• Availability of skilled labour - In Tirupur there is a pool of skilled machinists and pattern cutters. This
should make recruitment of textile workers with the necessary skills relatively easy.

• The reputation of the geographical area - This provides a firm with free publicity and exposure. For
example, Silicon Valley in California, an area with a worldwide reputation for software creation and
the development of information technology systems, has a large number of suitable skilled workers.

• Access to transport - Manufacturing firms benefit from being located near to major road networks,
pons and cargo facilities. A cafe or restaurant will benefit from being close to other shops, public
transport links and parking facilities. China has invested heavily in developing its infrastructure to
facilitate efficient transportation of finished goods to ports and airports. This gives it a competitive
advantage over India, where road and rail networks are less developed.

Diseconomies of scale

Diseconomies of scale arise when a firm gets too large and average costs of production start to rise.
Therefore, the disadvantages of growth start to outweigh the advantages. Reasons for increased
average costs of production include the following:

Internal diseconomies of scale

• Communication issues may arise when a firm becomes too large. There may be too many branches
to control and communicate with effectively, and decision making may be slow due to the number of
people in the communication chain. This may lead to increased costs of production.

• Growth resulting from a merger between two firms may be unsuccessful due to a clash of cultures,
so it may be beneficial to demerge. In 2010 the Fosters Group, which produces beer, sold off its less
profitable wine business as the merger had not brought about benefits of economies of scale. The
demerger allowed Fosters to focus on beer production again.

• It may be necessary to employ more employees for all the branches of the firm, or a new factory
may need to be built to accommodate the increased level of production. This will add to total costs of
production and average costs of production may rise.

• Workers within a large organisation may find it difficult to feel part of a large firm, so this may lead
to a lack of motivation and reduced productivity. Thus, average costs will tend to rise.

• The business may become too diverse and start to operate in areas in which it has less expertise.
Reduced control and co-ordination may cause costs to increase. Again, this can lead firms to
demerge.

• Jobs may be broken down into specialist parts and the workers may find their jobs too repetitive
and boring.