FORTUNE 500 2007  
FORTUNE 500    

The big... get bigger

As the 500 bulks up, the question is pressing: Why do some companies grow stronger with size, yet others stagger under their own weight? Come explore with us the scientific secrets of scale.

By Jerry Useem, Fortune contributing editor

(Fortune Magazine) -- My grandfather was born in 1904, a few months after the airplane. He never did believe something that big could fly. The scale he knew was Washington, Iowa, and the small college where he played baseball. When he arrived on Wall Street as a young lawyer, just in time for the Great Crash, he found himself working on the biggest merger that banking had ever seen: Chase's union with Equitable Trust. "I am sorry to see this merger come about," he wrote home in March 1930, "for I think these banks are getting too large and unwieldy." If my grandfather found that scale disconcerting, how would he - or anyone, for that matter - get his mind around a bank more than 40 times that size?

With boots, I decided, and a hardhat. I would scale the newest temple of commerce, the Bank of America tower that will soon be second only to the Empire State Building on New York City's skyline. When the heavy grate of the elevator swings open on the unfinished 37th floor, there is, technically, no floor. Just an expanse of rain-soaked, corrugated metal that at once provides a skeleton view of the building's vast interior and, near the edge, of Manhattan's Bryant Park and the corporate landmarks that Bank of America's crystalline pinnacle will soon surpass.

The symbolism of those towers, though, isn't simple. The names GE, Citigroup, and MetLife stand as tall on the 500 as they do on the skyline. But the Chrysler Building is a pointed reminder of companies - Pan Am, RCA, Woolworth - that have vanished from both. It's a bit perilous up here, in other words, and not just because it's too slippery to hang steel today. "Size seems to make many organizations slow-thinking, resistant to change, and smug," Warren Buffett writes in his most recent letter to shareholders. Yet his own Berkshire Hathaway (Charts), not known for such traits, now owns the No. 12 spot on the 500, ahead of IBM (Charts) and Boeing (Charts).

So is scale an asset or a liability?

This year's 500 suggests two different and wholly contradictory answers. On the one hand, Exxon Mobil (Charts) (No. 2) reaped the largest profit in history, $39.5 billion, while the entire 500 enjoyed its moneymakingest year ever. Amid all this, two of the largest titans were staggering under their own weight, one of them - Ford Motor Co. (Charts) (No. 7) - announcing its wish not merely to slim down but to grow smaller, as in "Atlas Shrunk." The No. 1 company, Wal-Mart (Charts), is under pressure to control a headcount that is nearing two million (putting it close to the People's Liberation Army of China, at 2.3 million) - but it can't open more stores without more people. Starbucks (Charts) (No. 310), meanwhile, which has 13,000 locations already, is adding them at the rate of more than 2,000 a year. Even as it throws itself toward its stated goal of 40,000, chairman Howard Schultz worries in a recent memo that the company's drive to "gain efficiencies of scale" has compromised the "soul" and even the aroma of its original stores.

And now, without further ado, the 800-pound gorilla.

The 800-pound gorilla is a unique subspecies that exists everywhere in business and nowhere in nature. Real apes max out around 400 pounds. But this is the important thing: Even if you could magically supersize a 400-pound gorilla into an 800-pound one, you wouldn't want to. Because the larger variety wouldn't be twice as scary. In fact, it would have trouble holding up its own body mass. This results from a fundamental rule that applies to animals, skyscrapers, and organizations: Scaling up is more than a matter of sizing up.

On the chalkboard, I will now draw a cube and a second cube twice as big per side. The surface of the larger cube is four times as big, and the volume eight times as big. Now we have learned the "Square Cube law." Meaning: The bigger an organization grows, the further away most of its people are from the outside world. Thus the tendency for organizations to become fixated on their own internal processes. Witness the astonishing 60-page artifact titled "On Being the Administrative Assistant to W.E. Burdick, Vice President, Personnel, Plans, and Programs." An excerpt:

  • Keep a supply of dimes with you. They are helpful when WEB has to make a call when away from the building.
  • Surprise birthday parties for WEB staff should be scheduled under the heading "Miscellaneous" for fifteen minutes & AA takes seat closest to the door to answer phones.
  • WEB enjoys Carefree Spearmint sugarless gum. When empty box appears in out-basket, reserve box should be put in his desk and new reserve box purchased.

Though it appears to be the work of Dwight from The Office, it is an authentic document of IBM, written in 1975 and cited by former IBM CEO Louis Gerstner in his 2002 book, "Who Says Elephants Can't Dance?" Gerstner's description of his arrival as an outsider at IBM sounds at times like Marlowe's account of his first encounter with the deranged Kurtz, isolated in the middle of a continent, in Heart of Darkness. It was unclear whether IBM's methods had become unsound & or if it had no method at all.

How to avoid that sort of insulation? Vanguard, which manages $1.2 trillion in mutual funds, has a policy for connecting employees to life outside the giant cube. Whether you're the CEO or a portfolio manager, or work in HR, you're required to spend one to four hours a month manning the phones and talking to customers.

Let's return to the chalkboard and look at another way of mitigating the Square Cube law: making new shapes. Take a sphere. A sphere works nicely for an amoeba, which can get oxygen through diffusion. But beyond a certain scale, diffusion doesn't do the trick, so an organism needs to build more complex structures - like the human lung, whose surface area is roughly the size of a tennis court. Scaling up, in other words, requires new design solutions. The ribbed vault, the pointed arch, and the flying buttress made cathedrals possible. The elevator and the steel I-beam brought the skyscraper. The telegraph and the railroad, likewise, enabled the large-scale corporation.

And another invention - the multidivisional structure - transcended the limitations of executive control. It's not enough to have just one design breakthrough: GM's Alfred Sloan invented the multidimensional corporation. Since his departure in the 1960s, however, the company that helped make America mobile has never really moved. By contrast, a time-lapse look at GE's 129-year history would look like a claymation film of shifting shapes and postures. Today its vast commercial finance unit has been simplified into nine "industry verticals" whose officers are as steeped in energy or aviation as the borrowers. This concentrates expertise at the point of contact - the sales front - where battles are won and lost.

The more battles you win, however, the more you have to fight basic math. Imagine a company with earnings of, say, $40 million, that promises to grow them by $10 million a year, every year, for ten years straight. If it delivers on that promise, it can look back on a decade in which earnings growth, um ... fell ... from 25% to 8%. No CEO goes around promising "steady, logarithmic growth." But that's what "grow or die" really means: You'd better grow, and also, you'd better grow the size of that growth.

Growth means different things to different companies. In 1964, GE had 262,000 employees and $237 million in profit. Since then, headcount is up just 22%, while profit is up 9,000%, to $20.8 billion. But for the big retailers on the 500, "growth" is much more literal. At Wal-Mart, headcount has risen almost precisely in line with revenue. Sales per employee last year were $184,000, nearly the same as in 1994, after adjusting for inflation. Analysts worry that Wal-Mart's administrative costs will grow to the point that revenues per employee will start to drop. Either Wal-Mart will come up with a radical new solution to this equation or it won't. Which brings us to the dying star known as Detroit.

It was here that the power of size was fully realized. Mass production - the conversion of high fixed costs into low unit costs - produced dramatic gains as long as there was enough demand to keep the works running full and steady. But if demand flags, siphoned off by better competitors, the equation is thrown into reverse. Supply demands demand, so the factory becomes a beast to feed. It's what drove Ford, in part, toward the folly of 0% financing - and to the brink of extinction.

Economies of scale, business historian Alfred Chandler wrote in "Scale and Scope," cannot be divorced from speed. Bulk multiplied by velocity produces a powerful momentum. Remember what Microsoft did to Netscape? But momentum is also a measure of the force required to stop oneself - and that's where giants are at a disadvantage. It's the difference, in aviation terms, between two famous fighters of World War II: the British Spitfire and the German Messerschmitt 109. The Messerschmitt had a bigger engine and could hit faster speeds, but the Spitfire's broad wings had almost 40% more surface area, allowing it to fly slower without stalling. That let British pilots make quicker turns and hold tight spirals that, in dogfights, turned the Messerschmitt's speed advantage into a liability.

The principle, extended to business, says: The shape you're in right now - however imperfect - has some advantage. Whatever it is, use it. To GE chairman Jeffrey Immelt, that means boldly exercising the strengths of being big, which includes taking risks that could ruin smaller players. "Our goal is not just to be big," Immelt wrote in the company's 2005 annual report, "but to use our size to be great." If there's one general rule: Scale is what gets you on the 500 list. It's how you use it that keeps you there.

Additional reporting by Doris Burke contributed to this article. Top of page

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