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Scale Economies

Discussion in 'Medium/Long Term Investing' started by RickyY, Nov 11, 2019.

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  1. RickyY

    RickyY

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    Scale economies is one of the seven moats of quality companies.

    Scale economies mean the fixed cost per unit falls as volume increases. Fixed cost is indivisible. And indivisibilities are more likely when an activity is capital intensive. The 3 main sources where scale arises are distribution, manufacturing and niche market.

    A dense distribution network allows a firm to spread its fixed costs over larger units which result in lower cost. Companies that deliver physical products such as courier delivery services like Federal Express, online retailer Amazon, or manufacturer like Fastenal that distribute fasteners enjoy distribution advantage when they serve more customers within a specific region.

    Manufacturing scale can come from capacity utilization; when machinery does an extra hour of work, fixed costs per unit falls as more units get produced. Scale isn’t limited to producing goods. It can be lower advertising cost with a larger client base; lower content production cost as it spread over a larger subscribers i.e Netflix; or learning curve that reduces fixed costs through operational efficiency. Just to name a few.

    While all these activities achieve scale economies but the important question is, how does scale economies become a sustainable competitive advantage? There has to be something that prevents others from doing the same thing for scale economies to become a moat.

    Minimum Efficient Scale
    Minimum efficient scale (MES) is the smallest quantity a firm must produce to become cost-efficient. As a firm produce more products, the total cost per unit gets lower. MES is at the point where the smallest scale meets the lowest cost. Beyond MES, all companies within the same market have identical cost. Not all cost curves are the same. Instead of an L shape, some resemble a U shape to show diseconomies of scale.

    [​IMG]
    For a firm to compete efficiently, it has to produce a quantity that is close to the industry’s minimum efficient scale. How does one get there? Through higher market share. It is only through more market share can a firm increases its volume and lower its total cost. But it isn’t as simple as it sounds.

    As a thought experiment, let’s say you make a dollar profit for selling a product in the market for $10. That’s a total cost of $9 for every unit sold. An incumbent has the same selling price but makes $3 profit (total cost of $7) due to scale economies. To get to MES, you lower your selling price to $9, a breakeven price, to gain market share. The incumbent follows suite. Matching your price in a tit for tat. After several rounds of price cuts, you found yourself sitting at a loss selling at $8 (a dollar loss per unit), far from achieving MES. The incumbent still enjoys a dollar profit at that selling price. This is the dilemma faced by new entrants in a market when there are scale economies: stay small at a cost disadvantage or get aggressive and fight a losing battle. Most of the time, incumbents would set an entry-deterring price that prevents any new entrants from entering the market in the first place. In this case, the incumbent would set its price at $8 from the get-go—a price enough to make a decent profit but one no firms would want to enter. Large firms capitalized on their size and turn it into a moat by charging a price that others are unable to match.

    Total Market Size
    Now you might think, what if the total market size is growing? Then this won’t have happened. Since the growing demand would satisfy the supplies produced by all the firms. And you’ll be correct. We can’t understand scale economies without talking about the total market size. We can explain the relationship between minimum efficient scale, total market size and the maximum number of competitors in an equation.

    Total market size ÷ Minimum efficient scale = Maximum no. of competitors

    The MES and the total market size of an industry determine the number of players in that industry. Why do some industries consist of only a few players? Think large commercial aircraft manufacturers (Airbus and Boeing), computer operating system (Windows, MacOS, Linux), global payments (Mastercard and VISA) etc. While others have hundreds of players from law firms to cleaning services and accounting firms?

    Monopoly or oligopoly markets are ones where the MES is large relative to the total market size. If the total market size of say, manufacturing bicycle frame is $100 million and the MES is $50 million, there can only be two players (100/50) serving that market. Any more players mean one or more of them will lose money in the long run. This is why Airbus and Boeing dominate the commercial aircraft market. While many factors shape the aircraft industry into a duopoly as it is today, the key reason remains that the development of new aircraft requires massive capital investment. And the difference between the MES and the total market size only allows one to two players to compete in the field. So much so that even if a new entrant has unlimited capital, it’ll lose money upon entering the market for not selling enough aircraft.

    On the other hand, there are hundreds of accounting firms, law firms, and cleaning services because these industries have little to no scale economies. Imagine a cost curve that is flat instead of an L shape. A 100 employees accounting firm has a similar fixed cost as a 3 employees firm. Most of the costs are variable like labor, training, computer software and so on. These industries are fragmented given the MES is small relative to the total market size. Therefore, allowing many competitors to coexist together.

    High growth and global
    What attracts firms to high growth industries? Revenue growth of course. Another less obvious reason is that it’s easier to enter a growth market. Just as MES as a percentage gets smaller when a market is growing rapidly, fixed costs become smaller as a percentage as the scale gets bigger. As a result, an entrant only needs to gain a small market share to reach MES. Recall the equation earlier, the faster the total market size (numerator) grows while MES (denominator) stays the same, the more competitors the market can accommodate. In other words, growth markets reduce the hurdles for entrants to compete efficiently. Therefore, firms operating in high growth industries rarely has any scale advantage over one another.

    The advantage of scale economies gets diminished when a firm goes global as well. A firm that has all of its manufacturing facilities on a single location has more scale advantage than one that operates across multiple countries. Fixed costs are not transferable. Each operation on a new location has its own fixed costs such as factories, plants, and equipment etc. Scale economies is also known as a ‘localized’ moat because it rarely extends itself to a global scale. Take economies of density, a form of scale economies where it is more cost-effective to serve 1,000 customers within a 1 km radius than 100 customers scattered across a 10 km radius. And its competitive advantage is determined by the route density within a specific region, not global.

    This is why when you look for scale economies, there’s a higher chance of finding it in a firm that serves a local market, especially one with a niche market. A firm in a niche market is like a big fish in a small pond. The market is only profitable enough for a single firm to operate because the efficient scale is the same as the entire market size.

    Technology
    Just as changes in the total market size determines the number of competitors and the dynamic of competition, changes in the minimum efficient scale have the same effect as well.

    Technology can either increase or reduce the MES. Technology typically lower cost but demand higher volume thus increases the MES (a shift to the right). Imagine you own a packaged food business where all the packaging are done through labor. Now a new technology came along where a packing machine can do all those work. But at a cost of $10 million, it has to pack 1,000 units per day to be more cost-efficient than manual labor. This machine indirectly increases the MES because other competitors now have to invest in this machine to compete efficiently.

    On the flip side, certain technology reduces the MES (a shift to the left). Thus reducing the barrier of entry. Solar efficiency reduces power plant scale, for example. 10-20 years ago, you need a coal power plant to produce electricity to be cost-efficient. But as solar efficiency improves and cost of solar per watt falls, it reduces the efficiency scale. Nowadays, you can install solar panels on your rooftop at a cost efficiency that rivals the cost of your local electricity provider.

    Barrier
    Business models effects efficiency scale as well. The two common methods are vertical integration and converting variable costs into fixed costs. Both of these tend to overlap.

    Everything that efficiently shifts costs from variable to fixed will reinforce advantages from scale economies. Take Xerox, the US company that sells print and digital documents products and services. Xerox pioneered the printer leasing business model. Think of those massive printers you use in the office. Instead of selling printers, Xerox’s lease and service business model reduces the upfront cost for their clients. At the same time, this increases Xerox’s assets and working capital. Meaning to compete with Xerox, all of its competitors have to increase their capital by owning those printers.

    This is also the reason why Amazon went from a capital-light business model selling products online to a capital intensive business acquiring Whole Foods stores and leasing 50 cargo airplanes. This forward integration increases the business’s capital intensity, making it harder for entrants to compete before committing to a massive upfront investment. In some cases, firms integrate backward up its supply chain not only to achieve scale efficiency but also to prevent entrants from having access to certain important raw materials.

    Either way, these vertical integration creates scale barrier because entrants face the cost of creating their integration. Further discouraging them from entering the market.

    Flywheel Effect
    The last thing to remember is that scale economies requires some form of customer captivity to become a sustainable moat. Companies typically do this using the ‘flywheel’. Consider SEEK Group, who owns several job sites such as SEEK, Jobstreet, JobsDB, Zhaopin etc. Due to its scale and being the first mover, SEEK managed to attract more and more job candidates to their website. This, in turn, attracts more employers to advertise their vacancies, which attracts even more job candidates. This is the first flywheel. SEEK then leverage on its scale advantage and the wealth of data generated by both candidates and employers to turn it into products and features that improve its job matching ability. Thereby, making SEEK even more attractive to both sides of users not just for its scale, but also for its ability to help employers reduce employment cost, improve productivity, and increase employee retention over time. That’s the second flywheel. The first flywheel develops an advantage through scale; the second flywheel reinforces the first flywheel by providing more value to its customers.

    Amazon uses a similar strategy to deepen its moat as well. It uses its size to achieve scale economies and lower its cost before passing those cost savings over to its customers, thereby attracting more customers who turn to Amazon as their primary shopping destination. This allows Amazon to further lower its cost and branch into other categories, increase its product breadth, and further solidify customer captivity. These flywheel effects reinforce one another to make it almost impossible for competitors to compete efficiently.


    Notes

    Jarillo, J. (2003). Strategic Logic: Palgrave MacMillan
     
    qldfrog likes this.
  2. qldfrog

    qldfrog

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    No denying and interesting, how do you apply this to investing?
    Looking at yearly report to calculate MES or keeping watch for any technological advance able to drastically change the status quo?
     
  3. peter2

    peter2

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    How about we use the "flywheel" effect of buying when the market is going up. This will provide an immediate boost to our portfolio. Then as the profits accumulate we re-invest the profits.

    The first flywheel is a rising market. The second flywheel is scale.

    If as a trader you find yourself digging a moat. Stop digging.
     
    Skate likes this.
  4. RickyY

    RickyY

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    I think you have taken the analogy too far but your 'flywheel' has diminishing return. In other words, it doesn't fly, it crawls. There is no 2nd flywheel because when you reach scale, your selling would cause the price to fall. That is called negative feedback loop.
     
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