Stop Paying the Complexity Tax

LinkedIn Article by Tim Williams 
April 8, 2013

Is growth always a good thing? The answer is not as obvious as it seems. While growth usually looks good on an income statement, growth also creates complexity. As your firm continues to expand and add services, your business model becomes more complex, and services become more expensive to deliver consistently.

In professional services, instead of creating economies of scale, growth actually produces diseconomies of scale. Because professional service providers are in the people business, not the manufacturing business, growth usually makes it more difficult for the firm to innovate, adapt, and serve its customers. Larger firms tend to have larger hierarchies that create significantly more overhead. How many professional firms achieve twice the efficiencies with twice as many associates?

The Diversification Discount

As firms like ad agencies grow, they almost always add more services, becoming more “generalized” and less specialized. When agencies reach this point of over-diversification, they run head-on into these “diseconomies” of scale. This is especially true if you are a “full service” firm, because it always costs more to serve the needs of a broad client base than it does a focused market.

This phenomenon is referred to in economics as “the diversification discount.” For the past several decades, economists have documented that the more diversified the company, the less valuable and profitable it is. Shares of large diversified companies trade at a discount compared to more focused companies.

In the land of the Fortune 1000, profit margins for diversified companies like ConAgra or Sara Lee are much thinner than for more focused companies like Coca-Cola or Wrigley’s. The same is almost always true in professional services. Global law firms may produce a lot more revenue than smaller focused firms, but they almost never match the profit margins.

Another dramatic example of the complexity tax is on display in the technology marketplace. HP, a company that struggles with profitability, has over 15,000 SKUs. Pretty complicated. Apple, one of the world’s most valuable and profitable companies, has about 60.

An Expense Item You Can Control

Imagine “complexity tax” as a line item on your income statement, right above “income tax.” The more diversified your firm, the more complexity tax you pay. While you may not be able to do much about your income tax rate, you can certainly lower your complexity tax. You do that the same way Apple does -- by doing a few things really, really well.