Economies of scale is a term that is thrown out quite a bit in the business world. On the west coast where I’m from, scale is a favorite term of tech entrepreneurs. Management and executives talk about leveraging scale. Investors seek out scalable companies. Every first-year business school student is familiar with the term. What are economies of scale and why does it matter in business?

Note: This week I’m in Toronto Canada for CCIF, the Canadian Collision Industry Forum quarterly meeting. The Canadians have a very robust automotive aftermarket, and own and operate some of the largest in the industry.  If you are in the area hit REPLY and let me know. It would be great to meet up.

What are Economies of Scale

Formally defined, and economy of scale is the reduction in average and marginal costs arising from an increase in size of an operating unit. In other words, the larger a business becomes, the lower the cost structure becomes. Developing economies of scale is like finding the holy grail. The more the business grows the more profitable it becomes.

Economies of scale are like moats. The more a company invests in developing them, the harder it is for competitors to breach the moat. But economies of scale are only built through investment. More specifically, they are built through re-investment. Building economies of scale requires a continued and ongoing investment into the business, growing the business to spread fixed costs over an increasingly larger base of revenues.

Building scale also requires an understanding of a company’s fixed costs, variable costs, and re-investment costs, otherwise referred to as capex, short for capital expenditures. Building scale may also require large initial investments that must be financed over time. Recognizing which financial levers to pull, and when, is an important part of building economies of scale.

Not All Businesses Can Build Economies of Scale

Economies of scale, when developed appropriately, are very powerful. Software is an example of an industry that benefits handsomely from economies of scale. For a software company, fixed costs are nearly identical whether the company services 1,000 or 1,000,000 clients.

But some companies are not well suited to building economies of scale. Companies that have a high degree of variable costs find it difficult to scale. Service dependent companies like restaurants, maintenance, legal firms, and other service based businesses find it challenging to build economies of scale because variable costs make up a large percentage of the overall cost structure of the business.

Companies in the automotive aftermarket fall somewhere in the middle. Paint and parts manufacturers, with large investments in fixed assets can benefit substantially from economies of scale. Distributors of paint and parts may also find benefits in focusing on developing economies of scale. The largest collision repairers have focused aggressively on building scale, spreading fixed expenses over an increasingly wider base of sales. But in each of the above examples, there is a component of variable expenses that influence the overall economics of the business.

Building Economies of Scale

Investors get excited by economies of scale. And rightfully so. Investing in economies of scale increases profitability, increases competitive pressure on other industry participants, and generally creates attractive returns.  Here are 5 ways you can go about developing economies of scale in your business.

1. Build a solid foundation. Developing economies of scale is all about the foundation. Robust accounting systems. Strong management systems. Established recruitment procedures. Invest in the foundational systems that will allow your company to become a much larger company.
2. Focus on scalable solutions. Often the best solution is not the cheapest solution. It may be tempting to focus on the low cost systems that don’t grow with your company. Or worse, increase in cost as your company grows. Developing economies of scale almost by definition involves investing in fixed assets that you can leverage as you grow.
3. Strategic planning drives success. Building economies of scale requires assessing where your company is at now, and comparing it to what your company will be when it is 10x or 100x the size it is today. The largest companies in the industry are all ones that embraced strategic planning and then execute according to the plan. Without a plan, building sustainable economies of scale will be challenging at best.
4. Understand your capital needs. Building economies of scale can take a lot of up front investment. But investors are excited by economies of scale because they recognize that the future return outweighs the cost of the up front investment. But poorly planned investments can quickly weigh down a company’s profitability. Build out a cash budget and realistically plan for you future capital and financing needs.
5. Think big – but protect your downside. Warren Buffett says it. Carl Icahn Says it. Even Donald Trump says it. These businessmen created their wealth by thinking big, but always protecting their downside risk. Building economies of scale demands that a business owner think of their business in much larger terms that it currently operates. Sometimes the best deal is the one you walk away from.

If you want to discuss how to develop the economies of scale in your business, get in contact with using my contact page. Our conversations are always confidential. Until next week!