This paper discusses the concept of returns to scale and its application based on the news article Why Financial Statements Don’t Work for Digital Companies (Govindarajan, Rajgopal& Srivastava, 2018), which was published on Harvard Business Review on February 26, 2018.
This news article focuses on the issue why investors react negatively to financial revenue losses for industrial companies but not have similar concerns for such losses of digital companies. The article starts with several cases of digital companies. Despite their losses before the IPO, both Uber and Twitter commanded positive valuations on their IPO dates. Furthermore, Microsoft was willing to pay $36 billion for the loss-making company LinkedIn and Facebook paid $19 billion to purchase the long term no profits firm WhatsAPP. On the contrary, the stock price of General Electric dramatically decreased by 44% in 2017 when it claimed the first loss during the past five decades. This paper does not differentiate returns of scale among different single companies but focuses on the fact that digital firm has significant increasing returns to scale in terms of intangible investments.
In economics, returns to scale describes the change in output brought about by the same proportion change of various factors of production within an enterprise. Returns to scale belongs the theory of long-term production, as only in the long run can an enterprise change all the factors of production. There are three types of returns to scale. The constant returns to scale (CRTS) refers to the condition when the output changes the same proportion simultaneously as that of various inputs. The increasing returns to scale (IRTS) happens when the multiple of output changes higher than that of various factors, if conversely, the situation should be named as decreasing returns to scale (DRTS).
Financial statement reasonably reflects the assets and revenues of an industrial company, but that is not the case for digital firms. There are mainly three reasons behind this phenomenon. Firstly, digital firms usually have more intangible assets than hard assets, while these assets are not capitalized as assets but expenses in the financial statement. Therefore, the more digital companies invest in its future business on intangible assets like research and development, brands reputation, customer relations, software development, and human capital, the more looses presented on their financial statements.
For another, the purpose of these intangible investments to digital firms are similar with that of plants and physical equipment to industrial firms dealing with physical inputs and outputs. Finally, and most significantly, digital firms tend to have ascendingly increasing returns to scales when they begin to have positive revenues. For one, intangible assets not only would not depreciate with use, but might increase. For another, digital companies might bring accruing value to existing consumers, and continuously enhance its value with the expanding of its consumer-social network. The initial investment of digital firms would gain ascendingly increasing returns to scales after its initial positive profits. However, due to the capacity limitation and depreciation, although some industrial firms have increasing returns to scale, these firms seldom can have continuous and soaring increasing returns to scale (Nicholson &Snyder, 2010).
In conclusion, digital firms tend to have high levels of increasing returns to scale than industrial firms. Never be depreciate but might appreciate with use, intangible assets like research and development and user and social relationships, and human capital might bring explosive benefits to digital firms when these assets accumulated to a certain level. Given that financial statements only capitalize physical investments and treats investments on intangible assets as expenses, these documents fail to reflect the real financial status and profitability of digital firms.