Why Businesses Grow (AQA A Level Business): Revision Note

Reasons for business growth

• Business growth involves a business increasing its size, scope or scale

• Their leaders or owners may have ambitions for growth for a range of reasons

The challenges of growth

• Growth brings clear benefits, but it can also create serious operational and financial problems if it is not carefully managed

• As a business gets larger, it can benefit from lower costs through economies of scale

• However, it also risks diseconomies of scale, synergy problems and overtrading

Diseconomies of scale

• Diseconomies of scale occur when a company grows too large to manage and control effectively

  • This makes it harder to coordinate departments, manage the workforce or maintain quality, which raises the cost per unit

• Further information on diseconomies of scale can be found here

Achieving synergy

• Synergy is the extra value created when two businesses combine their resources so that the joint result is greater than the sum of what each could achieve alone

  • This comes either from lower costs (cost synergies) or higher sales (revenue synergies)

• Synergies can be difficult to achieve in practice:

  • Cultural clashes

    • Synergy relies on people sharing ideas, data and resources

    • If two workforces have very different ways of working, projects may stall and expected savings may never materialise

  • Integration costs

    • Bringing systems, brands or supply chains together often costs more than expected

    • New IT links, staff training, redundancy payments and legal fees can spiral, reducing the savings or extra sales that were originally forecast

Overtrading

• Overtrading happens when a business tries to grow faster than its working capital can support

  • For example by accepting more orders than it can manage, opening new sites through heavy borrowing, or acquiring other businesses without careful evaluation

• Cash becomes tied up in inventory or unpaid invoices, while wages, suppliers and interest still have to be paid on time

• This limits cash flow and can force a business to borrow at high cost, sell assets in a hurry or, in extreme cases, fail

Example

Carillion signed many large contracts with payment terms stretching beyond 120 days. The up-front costs on these projects drained cash faster than income arrived

The company went into liquidation in 2018 owing around £7 billion while holding only £29 million in cash

Methods of growth

Organic growth

• Organic growth is growth driven by internal expansion using reinvested profits, owners' capital or loans

• Organic growth is usually generated by

  • Gaining greater market share

  • Product diversification

  • Opening a new store

  • International expansion

  • Investing in new technology or production machinery

Evaluating organic growth

External growth

• External (inorganic) growth is integration in the form of mergers, acquisitions or franchising

Methods of external growth

• A merger occurs when two or more companies combine to form a new company

  • The original companies cease to exist and their assets and liabilities are transferred to the newly created entity

• A takeover occurs when one company purchases another company, often against its will

  • The acquiring company buys a controlling stake (more than 50% of shares) in the target company's shares and gains control of its operations 

• Franchising is where a successful business lets other people open and run their own branches using its name, products and way of doing things

  • In return, franchisees pay an upfront fee and ongoing royalties, helping the original company grow quickly without having to invest all the money itself

• For a more detailed discussion of each of these methods, visit the revision note page Integration

Advantages of external growth

Disadvantages of external growth

High cost

• Acquisitions often need a large upfront payment, often funded through loans, increasing financial risk and straining cash flow

Integration difficulties

• Combining different systems, brands and processes is often more complex and costly than expected, meaning synergies may not fully materialise

Cultural clashes

• Differing management styles and cultures between the two businesses can cause conflict, lowering morale and productivity

Loss of control

• Funding an acquisition through issuing new shares dilutes existing shareholders' ownership and control of the business

Risk of overpaying

• Businesses often overestimate the value of, or likely benefits from, an acquisition target, leading to an inflated purchase price

Example

eBay paid $2.6 billion to acquire Skype in 2005, but failed to achieve the expected synergies with its online marketplace, and later sold Skype at a significant loss

Risk of losing key staff or customers

• Uncertainty during a merger or acquisition can prompt skilled employees to leave or customers to switch to competitors before the change has settled

Sustainable growth

• Sustainable growth means growing at a rate the business can support financially, operationally and culturally, while also considering its environmental and social impact

• Choosing to grow sustainably often involves a trade-off between slower, steadier progress and the temptation to expand as quickly as possible

Advantages of growing sustainably

Reduces the risk of overtrading

• Pacing a business's growth to match available finance and operational capacity helps avoid cash flow crises

Example

Riverford Organic Farmers has deliberately limited the pace of its expansion over the years, turning down opportunities for much faster growth in order to protect its quality standards and organic farming values

Protects long-term reputation

• Growing in an environmentally and socially responsible way builds trust with sustainability-conscious consumers

• This encourages customer loyalty and may mean a business can charge premium prices

Can improve access to finance

• Investors increasingly favour businesses with strong environmental, social and governance credentials, which can lower the cost of borrowing

Supports employee retention

• Steady, well-managed growth avoids the pressure that rapid, uncontrolled expansion can place on employees

• This helps retain skilled staff and protect the company culture

Challenges of growing sustainably

Missed market opportunities

• Growing more slowly and cautiously may allow less cautious competitors to capture market share first, particularly in fast-moving markets

Higher short-term costs

• Sustainable materials, ethical supply chains and environmental technology often cost more than the cheapest available alternative

• This can limit profit margins during a period of expansion

Difficulty in balancing competing goals

• Environmental, social and financial objectives can conflict with one another

  • For example, maximising profit growth may not sit easily alongside meeting environmental targets, forcing a business to make difficult trade-offs

Requires strong leadership commitment

• Shareholders sometimes push for faster short-term profits, which can push sustainable growth down the list of priorities

Risk of accusations of greenwashing

• If a business claims to be growing sustainably without genuine evidence to support this, the resulting reputational damage can be worse than not making the claim at all

Example

H&M's Conscious Collection faced accusations of greenwashing, since the brand continued to grow the overall volume of fast fashion it produced while marketing a relatively small proportion of more sustainable products

The impact of growth on functional areas

• Growth rarely affects only one part of a business

  • Decisions made to support expansion in one functional area often create knock-on requirements in the others