Economies of Scale?
The economies of scale of a value chain, or the Experience Curve as more traditional frameworks call them, explain how costs per unit reduce with an increase in production. For example, economies of scale enable a large drill manufacturer to produce drills at a cost per unit lower than a small manufacturer.
In short, we say that if your cost per unit decreases as your demand increases, then economies of scale exist in that process. If, on the other hand, your cost per unit goes up with a production increase then diseconomies of scale are taking place.
Because of its influence on costs, and in turn the competitiveness of your organization, the existence (or not) of economies of scale is something to look into as you plan your strategy.
Economies of scale are more significant in processes with a large portion of fixed costs, which may include capital investments and marketing among others. As the production of a process or operation increases, its fixed costs, which the company has to incur anyway, are spread across a larger output volume, hence reducing the final costs of running the operation for each unit produced.
Larger operations can also negotiate better pricing terms with vendors, helping reduce the final cost of each unit even more.
Economies of scale and learning curves exist in almost every industry, but they don’t grow indefinitely. In fact, in many
In the end, there’s only so much advantage that scale and experience can add, especially in a market with a number of equally-sized companies who relentlessly re-evaluate the optimal sizing and efficiency of their operations.
It is usually said that there is a minimum efficient scale, or MES, in every industry that a company has to achieve to get most of the benefits of economies of scale and operate competitively. Conceptually, economies of scale slow down above the MES, improving only slightly with the addition of new capacity.
Because of its direct relation to size and to the level of investment that’s needed to be competitive, the minimum efficient scale affects the number of players in an industry.
If the MES is low, as in retail or fast-food for example, the industry will tend to be fragmented with a large number of participants. If the MES is high as in, let’s say, the oil industry, the number of players will be low.
The nature of the economies of scale and the MES in a particular industry can have important implications in the strategic decisions its incumbents make.
When electric vehicle (EV) maker Tesla Motors (NASDAQ: TSLA) decided to manufacture its own lithium-ion batteries, it faced an industry of massive MES.
To target mass markets, Tesla had to make EV models in the $30-40,000 range and the only way to do this was by reducing its battery costs 30 percent, but to achieve such dramatic cost reduction, they needed to build a gigantic battery factory with enough capacity to serve half a million EVs a year, ten times the number of cars the company was making at the time.
This required a massive sales and manufacturing commitment from Tesla. It had to go from being a boutique car maker to becoming a mainstream player. Tesla partnered up with one of its vendors, Panasonic, to build the $5 billion facility in Nevada which came to be called the Gigafactory, which we cover in more detail in the book.
Another way to use economies of scale is to “forward-price” your products and services. That is, setting your prices based on the target capacity that your value chain will have in the future, rather than on the actual costs at the moment. With that, you seek to accelerate demand and get ahead of competition.
Finally, although they are not the norm, diseconomies of scale are also very frequent, and are usually found in operations that grow larger than management is able to handle. In this case, inefficiencies created by inexperienced or unprepared executives managing a more complex, larger operation, will tend to increase the costs per unit of the entire operation.
Of course, both economies of scale and learning curves are characteristics of a value chain that someone trying to copy a business’s products and services would have to replicate in some way.