© 2000 John Petroff

4)- Net profit margins and size of companies

There is a clear distinction between three groups of industries: those where economies of scale have a strong effect, those where they don't, and those where diseconomies of scale seem to be at work. Table T-13.12 previously presented is reproduced below. It shows the break down of eight industry median profitability measured by net profit margin (PBT/sales) reported in Robert Morris Associates for 1999-2000, by size of company in five size groups ranging from less than one million dollars in sales to over 25 million dollars.

Some sectors (e.g. retail and transportation) show not difference in profitability between small and large firms, while others (manufacturing and information) have increasing profitability with size,and still others (services adn utilities) have a declining profitability. To see the patterns more clearly, a graph is needed. The numbers are threrefore reproduced in Graph G-13.1.

The three sectors where diseconomies of scale seem to play a role are utilities, services and transportation. The moderate decline in profitability due to size of service firms can be expected. The ability of small businesses to cater to clients in fields such as building cleaning, employment agencies and detective services can be superior to that of large operations that fail to motivate employees. So is it true for the transportation sector with activities such as chartered buses, trucking, packaging, moving and freight forwarding. The sizable drop in profit margin of utilities firms as size increases is altogether surprising, but one may suppose that the fact the sector is regulated has something to do with it. Yet, one must remember that the profit margin is not the target: ROE is, and Table T-13.18, ROE in seven US sectors by size of sales in 1999, shows that large firms have more that twice the ROE of smaller firms. These two sectors, transportation and utilities, are the most leveraged sectors: they have the largest fixed assets and the largest proportion of long term debt (as shown in Table T-10.13, Normalized average balance sheet of eight US sectors in 1999). Consequently, ROE of larger firms is higher for larger firms even if their net profit margin is lower.

The three sectors where size does not matter are construction, retail and wholesale. In each sector, larger firms are still more profitable than small ones, but the difference is moderate to negligible. The fact that profitability of smallest firms is the lowest, may be somewhat distorted by the large proportion of firms in very serious difficulties which are either just starting or in the process of closing. If these smallest firms are disregarded, the remaining four groups show a combined increase from the group of 3-5 million sales to the group of over 25 million sales of only 25%. Intuitively, the healthy profit margins of small businesses in the retail sector is to be expected because of the personalized attention a small outlet can offer to discriminating wealthy customers.

The two sectors where size seems to matter a great deal, are manufacturing and information, as shown by the increase in net profit margin shown in Table T-13.12 and in graph G-13.1. The same argument of potential distortion of bankruptcies among very small firms appears to be even more appropriate in these sectors since a the majority of firms with sales under one million dollar lose money. Excluding these very small firms, the difference net profit margin between the next group and the group with the largest sales is, nevertheless, very substantial: 100%. For manufacturing, the large fixed assets and operating leverage explain the need for large size. But for the information sector, it is surprising. Surely enough, the information sector includes industries such as television broadcasting, publishing, motion pictures, telephone and cable, which are highly leveraged. But the sector also includes prepackaged software, computer processing, information retrieval and computer related services, which one would expect to be more alike service industries. Table T-13.15 shows the net profit margin (PBT/Sales) for computer related services and does not confirm that size does not matter: it certainly does. Graph G-13.1 also shows that the software and manufacturing sectors are very much affected by size.

See review questions Q-13D4.1 through Q-13D4.4.

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