After reading this article you will learn about:- 1. Causes of External Growth Strategy 2. Merits of External Growth Strategy 3. Limitations.
Causes of External Growth Strategy:
1. Economies of scale:
Small firms have limited resources (financial and non-financial) and generally produce goods at high cost. They buy in small quantities and, therefore, pay high price for materials and other inputs. External growth strategy results in bulk purchases and, therefore, low cost of production, low prices, high turnover and high profits. This is beneficial for both, consumers and the firms.
2. Concentration of power:
Big business firms have control over large share of national resources that provide them high profits. They are also the market leaders. The desire for profits and power builds business empires through this strategy.
3. Overcome the consequences of business cycles:
Business cycles represent the conditions of boom and recession. Boom is represented by high level of economic activities. Firms grow in terms of profits, turnover, employment etc. High growth rate results in unhealthy competition and external growth strategy is an effective means of checking this undesirable growth.
Recession is characterised by low level of economic activities. Firms face low demand, idle production facilities and unemployed labour. Capital remains tied up in unproductive assets resulting in losses. External growth strategy helps the firms overcome this situation. The evil effects of business cycles are reduced by this strategy.
Tariff means duty or custom to be paid on imports or exports. In order to protect domestic industry against imported goods, the government levies tariff on imported goods and provides protection to the home industry. Firms combine to take benefit of this protection and exploit bigger share of the market.
5. Development of joint stock companies:
Formation of joint stock companies facilitates business combinations. By acquiring shares of another company (inter-corporate investments), one company can acquire control of another company. It is easy for firms (which have common interests) to grow through external growth strategies.
6. Managerial ability:
All firms do not have professional ability to run their enterprises. Some enterprises have the organisational and managerial ability while others have strong financial base but low managerial expertise. External growth strategy helps in combining managerial and non-managerial abilities of different firms into one unit and makes best use of both to attain higher standards of performance.
7. Infrastructural facilities:
Strong infrastructure, means of transport and communication help in external growth in national and international markets. Infrastructure has promoted multinational corporations to operate their subsidiaries worldwide.
Diversification means entering into new lines of business. Businesses combine to diversify into new lines of products. When firms producing different products combine together, they diversify their operations into larger geographical areas.
Takeover of smaller units by bigger units or sick units by profitable units improves efficiency of the small or the sick units and also increases size of the bigger units. It increases the size of the asset structure and strengthens their financial performance.
Haney describes these factors as follows:
1. Driving or impelling forces:
These consist of cut-throat competition and less opportunities for speculative gains.
2. Beckoning forces:
These consist of opportunity for earning profits and protection to industries.
3. Facilitating forces:
These forces include tariffs and development of the joint stock company form of organisation.
Merits of External Growth Strategy:
External growth strategy has following merits:
1. High growth:
It eliminates wasteful expenditure and unhealthy competition and promotes cooperation and coordination amongst the firms. This results in optimum utilization of managerial and non-managerial talent and high growth of the combined firms.
2. Innovative management:
Business firms that combine together make best use of resources through R&D and use them to increase their price-earning ratio and market price of the shares. External growth strategy, thus, promotes innovative management.
It helps firms diversify into new markets, consumers and products and enlarge their scope of operations.
4. Economies of scale:
It increases the size of business operations. Combined firms enjoy economies of scale by making purchases and sales in bulk. Economies of scale reduce cost of production and firms earn profits through high turnover. They also make large sales by reducing the prices of goods.
5. Optimum utilisation of resources:
It helps in optimum utilisation of financial, human and physical resources resulting in quality output at minimum cost.
6. Synergical effects:
Synergy means the combined output of individual firms is more than their individual output. ‘One plus one makes eleven’ explains the effects of synergy. External growth strategy combines talents of two or more firms and improves efficiency of the combined firms.
It improves stability of earnings and sales by strengthening the capacity of firms to face business fluctuations.
8. Benefits of monopoly:
It pools resources of firms, combines their managerial talent, promotes cooperation amongst firms, eliminates wasteful expenditure, results in optimum utilisation of resources and provides a host of other benefits. The combined firms can make best use of their individual competencies, withstand economic fluctuations and strengthen their corporate interests.
Limitations of External Growth Strategy:
External growth strategy has the following limitations:
1. Concentration of economic power:
It concentrates economic power in few hands who may use it for their vested interests.
Though monopoly increases the size of business operations, it can be misused by the firms. Amalgamations and mergers form large-sized companies who may indulge in activities like high prices, restricted supply of goods, black marketing etc. to maximise the profits.
3. Sub-optimal utilisation of resources:
Combination of strong and efficient firms with weak and sick units can result in sub-optimal utilisation of resources. The desired level of profits may not be achieved.
4. Inefficient performance:
Competition promotes efficiency. Lack of competition gives rise to monopoly and promotes complacency on the part of firms to improve their performance. Firms may feel over confident that they can perform well merely because they are large in size. Investment in R&D tends to decline.
5. Loss of initiative for small firms:
Small firms that combine with big firms often lose their status and authority. Big firms suppress the creativity and innovative abilities of small firms. Small firms, thus, lose initiative to perform better. It can also form large-sized firms who acquire monopoly power that can threaten the survival of small firms in the market.
6. Over capitalization:
Pooling of capital resources increases the amount of capital but not necessarily its efficient use. Inefficient use of capital does not increase the size of assets. The earning capacity of assets being lower than the corresponding amount of capital results in over capitalisation.
Over capitalisation is not desirable for the company, shareholders and society. Unless, therefore, pooled capital resources result in corresponding increase in the earning capacity of firms, this strategy is not desirable.
Larger the size of business firms, greater the possibility of government interference in business matters. Excessive Government interference can expose them to greater political and economic risks. External growth strategy is good but its limitations should be avoided. Its greatest evil is monopoly.
The Government, therefore, regulates anti-monopoly laws to smoothen the functioning of firms that have monopoly powers because of external growth strategy.