Latticework of Mental Models: Economies of Scale

“Do we have flexible working hours here?” That was the first question I asked when I joined my first job in IT industry.

“Yes. As long as you get your 40 hours in at the end of every week.” Informed my new boss.

That was a great deal considering the previous 9-hours-6-day job I had in a manufacturing industry. Forty-hour week was even better than the schedule I had during my school days.

In India the culture of forty-hour week became more popular with growth of IT industry. Have you ever wondered how this idea of forty-hour week came to be?

The credit for our 8-hour-5-day work week goes to an unsuspecting guy called Henry Ford, the founder of Ford Motor Company.

Until 1900 most industries used to have 100-hour work weeks. But in 1914, Ford Motor Company took the radical step of cutting the work-shift duration to eight hours. This was an unconventional move in those times but when this change saw an increase in Ford’s productivity, other companies followed suit and soon the 8-hour-day became the norm.

But the question is, how did the productivity increase with reduction in work hours?

Well, technically the productivity increase wasn’t the result of reduced work hours. It was other way round. Because of certain characteristics of Ford’s manufacturing process, the productivity sky rocketed and Henry Ford figured that he could cut his employees some slack and allow them to enjoy more free time. No wonder Ford Motors was considered the best place to work during 1920s.

So what was the secret behind Ford’s unusual efficiency? The answer in the simplest form is – Economies of Scale.

Economies of scale are simple economics where the costs of your product or service decreases as the volume increases. Ford’s manufacturing processes increased the efficiency which resulted in cheaper cars which in turn created more demand and a positive feedback loop got created.

Ford converted the automobile from an expensive curiosity into a practical conveyance. He mastered the art of mass production and perfected the assembly line production technique (for example, Model T was produced only in black colour because it was quicker to dry and proved cheaper) to bring down the cost of producing cars. I don’t need to convince you about the enormous impact Ford had on the way mass production is done. The facts speak for themselves.

Between 1908, the year of introduction of Ford Model T, and 1927 a total of 15 million Model T cars were produced. That was a staggering number. In 1918 more than half of all the cars on American roads were Model T. With in few years of launch of Model T, Ford was able to bring down its price by 45 percent. All because of huge economies of scale working in favour of Ford.

A company may reach a certain critical size, writes Peter Bevelin in his wonderful book Seeking Wisdom, “and get advantages of scale in experience, purchasing, marketing, manufacturing, administration, research, logistics, distribution, etc. For example, expenses can be spread out over larger amounts of volume, lowering average costs. These advantages often permit greater specialization, making people better at what they do.”

Fixed and Variable Cost

To understand economies of scale, it’s important to remember the difference between fixed and variable costs. Fixed costs are defined as expenses that do not change as a function of the activity of a business. It includes the land, buildings, vehicles, plant and machinery, R&D, advertisement, etc. For example, a retailer must pay rent and utility bills irrespective of sales.

On the other hand, variable costs are volume-related and are paid per quantity produced. It includes cost of raw material, packaging, taxes, transportation, and other operating expenses.

Typically, the closer a factory is to its full capacity, the more profitable it is, and the larger the factory, the easier it is to spread fixed costs like rent and utilities over a larger volume of production. Also, the larger the factory, the easier it is to specialize by individual tasks or to mechanize production. This specialization and mechanization was the foundation of assembly line production and made 8-hour day possible for factory workers.

For example, let’s say the yearly fixed cost of setting up and running a car manufacturing unit, with capacity of 10,000 cars per year, is Rs. 100 crores and the variable cost of building a car is Rs. 1,00,000. There are two car companies A and B with same capacity.

• Company A is selling 5,000 cars per year. So the total variable cost becomes 1,00,000 X 5,000 = 50 crores. Which means the cost per car for the company is 150 crore / 5000 = 3,00,000.
• Company B is selling 9,000 cars per year. Here the total variable cost becomes 1,00,000 X 9,000 = 90 crores. Based on this the cost per car for this company is 190 crore / 9000 = 2,11,111.

Clearly, company B can price its cars much lower than company A and still make profits. And it doesn’t stop there. Because of lower price, the demand for company B cars will increase which in turn will lower its cost further and generate more profits for company B. Therefore, we can say that Company B is enjoying an economy of scale here. That’s what happened with Ford’s Model T.

Moat and Economies of Scale

Moat is a metaphor that Warren Buffett often uses to describe the durable competitive advantage of a company. Pat Dorsey, in his book The Little Book That Builds Wealth, identifies cost advantage as an important source of moat. And one of the places where cost advantage can stem from, as we saw in the car example, is economies of scale.

Scale advantages can create extremely durable economic moats. One of the example that I can think of in Indian context is VMart.

VMart is in the business of value-for-money retail stores in Tier-2 and Tier-3 cities. In last four years, as VMart store count has increased rapidly its net profit margin has grown from 3.7% to 5.2%. Those are great numbers for a retail business. This improvement is the result of increased efficiency of operations which in turn was made possible by opening the new stores in a clustered mode which lets VMart create economy of scale. In fact, that’s the approach Walmart has taken in the past few decades to expand its retail chain all over the world. And if there’s one word which describes the success of Walmart, it’s economies of scale. (We covered VMart in detail in our March issue of Value Investing Almanack)

In technology, companies which sell software products benefit from economies of scale immensely. For a software product company selling antivirus software, there is a certain capital required to develop and market its product. But once the product starts selling, creating additional unit of the product doesn’t cost anything extra (except may be the miniscule cost of packaging it in a CD/DVD). If the product has large consumer base, revenue from every piece of software sold flows directly to the bottom line.

It’s important to note that economies of scale doesn’t necessarily create moats.

This is true especially if the business is into manufacturing undifferentiated (or commodity) products. In the car example, if company A manages to sell as much cars as B then in spite of lower unit costs for both, A and B will ultimately get into a price war assuming there isn’t huge difference in the quality of their cars. This is what happened with even Ford later. As other car manufacturers caught on with Ford’s level of productivity, Ford’s competitive advantage created by economies of scale disappeared.

Aviation industry is a good example where economies of scale creates a situation of price war between airlines since they are into a commodity business (flight seat is an undifferentiated product hence a commodity).

However, for a private jet company like Netjets, in spite of being in aviation industry, economies of scale can create a moat. While discussing about Netjets, Warren Buffett says –

Both we and our customers derive significant operational benefits from our being the runaway leader in the fractional ownership business. We have more than 300 planes constantly on the go in the U.S. and can therefore be wherever a customer needs us on very short notice. The ubiquity of our fleet also reduces our “positioning” costs below those incurred by operators with smaller fleets. These advantages of scale, and others we have, give NetJets a significant economic edge over competition.

Charles Munger tells us about another kind of advantage of scale:

In some businesses, the very nature of things is to sort of cascade toward the overwhelming dominance of one firm. The most obvious one is daily newspapers. There’s practically no city left in the U.S., aside from a few very big ones, where there’s more than one daily newspaper… Once I get most of the circulation, I get most of the advertising. And once I get most of the advertising and circulation, why would anyone want the thinner paper with less information in it? So it tends to cascade to a winner-take-all situation.

A similar effect of economies of scale, cascade toward the overwhelming dominance of one firm that Munger talks about, can be seen in a handful of modern technology businesses like Google, Amazon and Facebook. Economies of scale, by virtue of characteristics like strong network effects and large distribution networks, shifts the scale towards the market leaders so much that others find it impossible to make a dent into the existing moat.

Today the cost of getting a new user to sign up is almost zero for Facebook. Similarly, the cost of getting a new smartphone to install Android OS in it is again zero for Google. The cost of delivering an e-book to a user is zero for Amazon.

Bigger Isn’t Always Better

Please note that being bigger is a necessary condition for economies of scale but it’s not a sufficient condition. A business where fixed costs are very low as compared to variable cost, there’s no economies of scale. For example, a law firm with thousands of lawyers has no cost advantage over a law firm with 10 lawyers. It may have a greater range of services it can offer, and it may get additional business from that angle, but it is not going to have a meaningful cost advantage over a smaller competitor.

In other words, for businesses with higher level of fixed costs relative to variable costs, increase in scale of operations increases the profit margins rapidly. Whereas in a business where the fixed costs are relatively lower, with increase in scale, in spite of increase in net profit, the profitability doesn’t increase as much.

Interestingly, there is something called Diseconomies of Scale too.

At some point the disadvantages of business size may eat into the advantages, writes Bevelin, “For example, increased costs and investments, per-unit cost increases, systems become too complicated, bureaucratic and inefficient, etc. People’s behavior may change when we change the scale of a group. What works well in a group of one size may not work at all in a group of another size.”

So Amazon can deliver the latest book cheaply to your doorsteps but it can’t provide the ambience of a cozy reading space. Amazon can recommend you the next book based on your purchase history but it can’t create the warmth of a friendly staff willing to guide you through the aisles between book shelves. Economies of scale fails to deliver value in such scenarios.

Conclusion

Jamie Dimon, chairman and CEO of JPMorgan Chase, said –

Economies of scale are a good thing. If we didn’t have them, we’d still be living in tents and eating buffalo.

If you think about it economies of scale is common sense. In fact, if you know basic geometry, economies of scale should be pretty obvious to you. Here’s how.

Why do the oil and water tankers have a cylindrical shape?

If you’re building a big cylindrical tank, as you build it bigger, the amount of steel you use in the surface goes up in proportion to the square of the dimension and volume goes up in proportion to the cube of dimension. So as you increase the dimensions, you can hold a lot more volume per unit area of steel with a cylindrical shape. Therefore, building a cylindrical container is more economical than a cubical container.

I wish my maths and economics teachers had their lunch together and figured out this connection. My classes would have been lot less boring and I wouldn’t be complaining about my gruelling school hours.

Take care and keep learning.