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Economies of Scale

The most time-tested method of creating cost advantage is to create economies of scale. The great companies from the industrial revolution — railroads, steel, oil, banking, and automotive manufacturing — all utilized economies of scale. After a certain level of production, or scale, was achieved, significant cost savings or additional profits were achieved. These economies of scale acted as a barrier of entry for competition or as a profit buffer.

For example, a small pharmaceutical company can create an innovative prenatal vitamin. Because the company is small, it can purchase only tiny quantities of the chemicals needed to produce the vitamins. At its current low volume, each bottle of vitamins costs the company $10 to produce. To be in line with the going market price, the company must sell the vitamins for $20 a bottle.

With only a 50-percent gross margin, the small pharmaceutical company has little money to hire talented scientists and engage in additional research. The volume squeeze puts it at a competitive disadvantage. If the company can double sales volume, it can justify purchasing truckloads of chemicals instead of small pallets, reducing the cost per bottle of vitamins to $7 each, and greatly increasing the competitive position of the company.

Economies of scale can affect all aspects of a business, not just purchasing power. McDonald’s 14,098 locations dwarf the next closest hamburger chain Wendy’s 5,876 locations. Assuming each chain spends the same amount per location on advertising, McDonald’s spends triple the amount Wendy’s does promoting its burgers. This marketing economy of scale serves McDonald’s in several ways.

First, the average person sees a McDonald’s ad three times more often than a Wendy’s ad, which should lead to greater sales. Second, McDonald’s has more locations at which to purchase hamburgers, so the advertising has a greater chance of pulling a consumer into a McDonald’s. Third, the large marketing expenditure created by combining 14,000 locations creates a massive moat protecting McDonald’s from competition.

The industrial revolution is over, and gone with it is some of the power of economies of scale. Today, businesses of all sizes can compete with large multinational corporations, particularly on the Internet. The Internet acts as a great equalizer, allowing small companies access to business resources previously reserved for large companies. The Internet allows businesses to

  • Reach customers all around the world without the expense of a physical outlet.

  • Market products very inexpensively.

  • Attack previously unprofitable, tiny niche markets.

  • Access vendors and talent from around the world.

  • Operate virtual offices, eliminating the need for expensive overhead.

  • Teleconference and videoconference for little or no money, eliminating the need for expensive travel.

By leveraging the Internet, companies of all sizes can remove the barriers of economies of scale.

When Amazon.com was launched, Jeff Bezos was operating out of his garage. Today Amazon boasts sales in excess of $50 million annually. Google was a school project of Serge Brin and Larry Page. Mark Zuckerberg was horsing around when he created Facebook in his dorm room. Some of today’s largest and most profitable businesses started as tiny ventures that leveraged the Internet.

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