Economies of scale as a phenomenon goes back to Adam Smith, so it is, unsurprisingly, often described in industrial terms. It is the phenomenon where per unit costs decrease with increasing volume or throughput (i.e., output produced per unit of time).
This can result from quite a few different factors – such as:
- The division and specialization of labor.
- The increasing efficiency of manufacturing facilities at larger scale, volume, or throughput.
- The friction loss of transportation and industrial equipment.
- The physical and geometric properties of pipelines, vats, and other production facilities (i.e., the volume increases greater than the surface area of the materials).
But economies of scale has long since been expanded as an idea beyond just production and manufacturing. It is the idea that operations and organizations can become more effective and efficient with increasing size. This can result from all sorts of factors that improve with scale – such as:
- Purchasing activities. Larger companies can buy in bulk through long-term contracts, resulting in better prices and payment terms.
- This also includes financial services, such as lower interest loans from banks. And access to a greater range of financial instruments.
- Managerial performance. Larger scale enables increasing specialization of managers.
- Marketing spend. Where the cost of advertising is spread over a larger volume, resulting in an increased ability versus smaller competitors.
- Technology spend. This shows up in R&D and investment in technology. But also in production efficiency and effectiveness.
Overall, going for scale is still the default competitive strategy. Being bigger than a competitor gets you a lot of advantages. In digital, the default strategy is going for economies of scale on both the demand side (i.e., network effects) and the supply side (usually in fixed costs). And it’s more effective when you do this in a specialized field. That’s YouTube, TikTok, Facebook and Google Search. When in doubt, get bigger.
I break economies of scale into the following categories of competitive advantages:
- CA11: Fixed Operating and Capital Costs
- CA12: Purchasing Economies and Bargaining Power with Suppliers
- CA13: Geographic and Distribution Density
- CA14: Geometry Effect
- CA15: Learning Scale
CA11: Fixed Operating and Capital Costs
When people talk about economies of scale, they are usually talking about economies of scale in fixed costs. They do a quick check for large and mostly fixed costs on the income statement. They then divide these by volume (or revenue). And they see if the larger competitor has lower per unit costs. For example, a larger factory, which has significant fixed costs, usually produces widgets cheaper than a smaller factory. It looks like this:
That’s the simple version of economies of scale in fixed costs. But there are some important complexities. The first is that you need to look at all the ongoing operating costs and operating assets.
- You can’t just look at the operating costs of the factory this month or this year. You need a rolling average for an average volume.
- Plus, you need to look at the capital costs required to create and maintain the factory at this average volume. That means looking forward and backwards in time in capital spending on the big tangible operating assets.
- Finally, you need to think about other capital costs such as working capital and ongoing intangible operating assets.
A simple example is when two companies have the same fixed operating and capital costs but different volumes (and revenue). As shown below.
Some of my standard questions for scale advantages are:
- What is the company’s per unit costs versus its competitors for a given volume per set time? What is the Long Run Average Cost (LRAC)?
- What economic value does the scale differential capture?
- What is the surplus margin leader value?
- What is the minimum efficient scale for this product or service?
- Is there indivisibility? Are the costs fixed at a minimal point regardless of volume?
You can see most of the key terms in the above graphics. Ideally, we are looking for a scale advantage where:
- The scale differential is large and creates a lot of economic value for the leader.
- The minimum efficient scale is large.
- The cost structure is largely indivisible.
However, in practice, it is more complicated than this graphic. The distinction between fixed and variable costs is not this clear. Most companies with larger scale also have larger fixed costs. They just go up slower than the volume. It looks more like this.
And there is a lot of judgement involved. What costs really matter in a business? Is about having a cheaper factory? Or is about outspending competitors in strategic areas like IT and R&D?
My Questions for Economies of Scale in Fixed Costs
For CA11: Fixed Operating and Capital Costs, you really want to look at both operating performance and operating assets. The latter is more complicated. Here are some standard questions.
- What percentage of the operating costs are fixed vs. variable for the same range of volume?
- Some operating costs are quite variable, such as COGS for retailers. However, the staffing costs at hospitals are largely fixed.
- What percentage of the capital costs are fixed vs. variable for the same range of volume?
- Break this into:
- Working capital
- Tangible operating assets
- Intangible operating assets
- Note: Fixed vs. variable is mostly about how fast the operating assets can be scaled up and down. Starbucks outlets are variable as they are easy to open and close. Others operating assets like hotels and factories are mostly fixed capital costs. They sit with idle, unused capacity when volumes drop.
- Break this into:
- What scale differential between the two companies results in a meaningful competitive advantage?
- Which operating costs and / or capital costs matter?
- What differential creates a competitive advantage?
- What is the minimum viable scale for be a new entrant?
- Which operating costs and / or capital costs matter?
- What is the required baseline for the key operating assets?
- Break this into:
- Working capital
- Tangible operating assets
- Intangible operating assets
- What is the ongoing maintenance capex to keep the operating assets at their current levels?
- Certain operating assets, like mobile networks, require significant ongoing upgrades.
- These are fixed costs in most cases. Operating assets that depreciate or are disposed of rapidly provide less competitive strength. It makes them closer to variable costs.
- Growth capex is different.
- How are the costs of the operating assets (both tangible and intangible) rising and falling over time? Historical vs. current costs of operating assets can be important.
- Real estate assets increase in cost over time, which means past historical costs can put the incumbent at an advantage versus a new entrant. It effectively decreases the scale differential.
- But software and technology costs decrease over time so past historical costs disappear quickly. However, maintaining older versions of software can create legacy costs that new entrants don’t have.
- Break this into:
All of this gets really interesting when you start looking at digital companies. Everyone always talks about how the marginal cost of production of software is very small. But the operating costs and operating asset picture for digital businesses is actually a mix of positives and negatives. Yes, capacity for software can increase without additional operating costs or operating assets. But the maintenance of complex software can be very expensive. Customer service can be a nightmare. And upgrades are much more frequent than with say factories.
Example: Why Warren Buffett Bought Airlines in 2016
Delta and American Airlines have built national networks based on a hub-and-spoke model, to which they added regional feeder airlines and international partners. These airlines are competing on variable costs and also on economies of scale. Really, they are competing on costs across every dimension. Passenger air travel is overwhelmingly a commodity service and customers will switch for the smallest of price savings.
The big US airlines, Delta, United and American, obviously have very large fixed operating and capital costs. They have their fleets, ground operations and expensive staff. Achieving greater volume and utilization of this mostly fixed capacity versus competitors is critical. They focus on cost metrics like the average seat cost per mile flown. Second to that, they compete on metrics such as frequency, available routes and timing. All of this depends on driving volume in their network. This is why the regional feeder airlines are so important. They feed volume to the mainline network.
In 2016, Warren Buffett revealed he had acquired major stock positions in American, Delta, Southwest, and United Airlines. This was a big surprise to Buffett followers because he had long described airlines as some of the worst investments. In his 1992 shareholder letter, he said “Investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth…The more the industry has grown, the worse the disaster for owners.”
And he discussed the competitive dynamics of the industry, saying “I knew the industry would be ruggedly competitive, but I did not expect its leaders to engage in prolonged kamikaze behavior…here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers.”
But when Buffett invests there is almost always a competitive advantage. In fact, his investments usually have three characteristics:
- Stable and rising demand.
- A competitive advantage.
- Limited exposure to external changes like government action and technological change.
So here’s why I think he bought.
- The industry had consolidated to 4-5 major airlines that all had significant competitive advantages relative to the smaller players. They were very well defended by scale.
- The 4-5 major airlines did not have scale or other competitive advantages against each other. But management was no longer doing kamikaze behavior. They were more collegial and were all making profits and doing buybacks.
So, Buffett bought all of the leaders at scale. That way he captured the entire profit pool without having to choose the individual winners. It wasn’t clear who would make the most profits. But it was clear that the 4-5 leaders all had big scale (and other) advantages against everyone else.
That said, it’s not clear he was right. He exited all these investments during Covid saying the industry had fundamentally changed. But I think I’m right about his competitive advantage thinking in 2016.
We can actually see other scale effects in the airline business.
- The planes get more efficient as they get larger. Larger planes can hold more people but don’t require a proportional increase in the amount of steel. The volume increases more than the surface area.
- Larger planes also don’t require a proportional increase in the number of engines with size.
- They also don’t need proportional increases in crew size. Two pilots can fly both small and large planes.
That’s it for today. Cheers, Jeff
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- 3 Big Questions for GoTo (Gojek + Tokopedia) Going Forward (2 of 2)(Winning Tech Strategy – Daily Article)
From the Concept Library, concepts for this article are:
- Economies of scale in fixed costs
From the Company Library, companies for this article are:
- n/a
Photo by Alexei Maridashvili on Unsplash