Saturday, November 13, 2004

Economies of Scale

Some McDonald’s restaurants are “outsourcing” order taking. So when you shout at the little box on your way to the carry-out window, you give your order to someone in a remote location who is answering for several restaurants.

McDonald’s is exploiting the concept of economy of scale, one of the most misunderstood economic ideas around. Cost reduction resulting from economy of scale was one of the main justifications for the hospital merger mania of the 1980’s and 90’s. It was almost always false. More often than not, those mergers caused diseconomies of scale with costs going up, not down.

The idea of economy of scale is attributed to Adam Smith, the legendary 18th century Scottish philosopher who wrote the book Wealth of Nations. Using a pin factory as an example, he observed that if each worker performed one of the separate functions involved in pin making, they could together make more pins than they could if each made a complete pin by himself.

Of course, you had to make enough pins to fully occupy several workers, which has led to the erroneous conclusion that the increased efficiency was due to volume – thus the term “economy of scale.” In actuality, however, the efficiency was due to the specialization of labor that the volume permitted.

In the case of McDonald’s, it seems that workers who took orders also had to prepare food. Information technology allowed order taking to be consolidated off-site, thereby making it possible for workers to do it full time. The result has been higher sales (order-taking specialists are better salespersons) and faster, more accurate service (because full-time order takers are more proficient).

Health care providers have done a lot of specializing. Recent examples are hospitalists (doctors who work full-time caring for inpatients) and intensivists (doctors who work full-time providing intensive care).

But hospitals never said they merged in order to become large enough to afford hospitalists and intensivists (actually, most of them were big enough for that already). Instead, they claimed that their overhead departments like purchasing and payroll could “absorb” the extra work without growing proportionally. If that were true (and it usually wasn’t), the economies were more than offset by the added bureaucratic effort needed to manage the larger and more complex operation.

Health care providers need to learn to exploit economy of scale in the same way that McDonalds has. For example, a large hospital with a busy Emergency Department could have Physicians Assistants or Nurse Practitioners specialize in the care of stroke patients. Thoughtfully applied, that sort of innovation could make a significant contribution to both quality improvement and cost reduction.

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