Economies of Scale vs Scope

Two of the most valuable concepts in economics for entrepreneurs are about how growth can improve your bottom line:

1. Economies of scale tell you how running a bigger business can increase your profit. Not just your total revenue, which is fairly obvious: if you’re selling 100 units at $10 each, you make twice as much revenue as if you’re selling 50 units at the same price.Economies of scale are when some of your costs can be spread out through all of the units you’re selling, such as fixed costs — things you have to pay for whether you make anything or not. For example, if you’re selling widgets that are made in a factory, then you have to pay rent and wages no matter how many widgets are sold.

   Let’s use $10,000/month as an easy round number. (Maybe it’s a really small factory.) That means that if you sell only one widget, the amount of rent per widget is $10,000. But if you’re selling 10,000 widgets, the amount of fixed costs that each widget pays for is only $1.

   This is a big deal, because at one unit you’re losing money. If you’re selling units at $10 each, then you’re losing at least $9,990 per unit on the sale of the first unit. But once you’re selling 10,000 units, then you’re making $9/unit, and that’s $90,000!Advertising works the same way: if you pay for advertising at $10,000/month you have the same problem at low levels of sales and the same advantage at high levels of sales. There can be a big advantage for a large company that has been advertising for a long time, because advertising takes time to build momentum (people need to see an ad many times before making a purchase) and because advertising has economies of scale, too. For example, a large print ad can be much, much more effective than a small ad, but it also costs a lot more. If you’re a small company you can’t afford the ad campaigns of a larger company, so your advertising has a higher customer acquisition cost (CAC).

   Software has enormous economies of scale, because once the money has been spent to develop the software (eg. programmer time) the margin cost per unit sold is relatively low. (Marginal cost means “how much more it costs to provide one more unit.”) The expensive part per unit is usually related to support. So if you are paying two programmers at $5,000/month (for that convenient $10k number again) then it’s the same math: if you sell only one unit, the programmer cost is $10k, but if you sell 10,000 copies per month then the programmer cost is only $1/unit.

   This effect is displayed in the graph below, where “LRAC” is the long run average cost, defined as the average cost per unit over the long run, defined as a period long enough that you have time to adjust all of the costs that go into making the product.

   For example, in the short run you can’t rent a different sized factory every single day, or hire and fire workers every day, but over a long enough period of time you can move to a new factory or adjust the size of your work force. With that taken into account, there’s a period where the growth of the business (eg. selling more units) can reduce the average cost per unit. And as you can see on the graph, there’s also often a point where the economies of scale disappear and turn into diseconomies of scale. That’s the kind of problem most entrepreneurs start by dreaming they’ll one day have.
   
   Economies of scale are crucial to entrepreneurship, product design and management. If a business doesn’t have good economies of scale (eg. if you pay the same amount of costs per unit whether you sell one unit or 10,000) then it’s often not as profitable a business. This isn’t always true–in very rare cases it might just be profitable at all levels of sales, which can be fantastic, but then you usually have another problem: barriers to entry. If a business can experience full levels of profit at low levels of sales, then too many business will enter the market, prices will drop, and suddenly profit margins are too low to make it worthwhile.Usually entrepreneurs seek to find a business that doesn’t intrinsically scale well, and to figure out how to make it scale better, so that it’s hard for other people to compete. That was what Henry Ford did with cars.

2. Economies of scope is a similar but different concept: it’s not about making a lot vs. a little of the same product, but about making different but compatible products.For example, if you make apple juice then you can probably use a lot of the same equipment for making orange juice, so you save money per unit because you’re increase the scope (range of products) within similar categories.

   Similarly, if a customer already trusts AquaColCrest toothpaste, they might be more likely to buy toothbrushes or teeth whiteners from the same company, so expanding the range of products that AquaColCrest offers would likely be successful as long as they stick to new products that can leverage their existing resources (eg. use the same factories, marketing methods, distribution channels, retailer relationships) and appeal to the same customer base.

   Google, Microsoft and Apple use this all the time: you use GMail, how about Google Calendar? You have an iPod, but it works even better with an Apple TV and an iMac!

   Economies of scope are relevant to entrepreneurs both when deciding whether or not a second product or product line makes sense, and also in deciding whether a business idea is viable. If the first product of a business naturally leads to other related products with good economies of scope, that can have a similar effect to economies of scale.

   On the other hand, it’s probably a bad idea to expand the business with a product where there aren’t economies of scope. Apple is one of the best examples of this, sticking very closely to a limited number of products that all work together.

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