Lesson 4 of 8
Scale that is real
Being large is not scale. Scale is holding more of a market than anyone else, so a fixed cost nobody can avoid is spread over more units than a rival reaches.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- Scale is relative to a market, not absolute. A national company with 3 percent of each region loses to a regional one with 40 percent of one.
- The cost that creates scale has to be indivisible: something a competitor must pay for in full to serve the market at all.
- A large company with no indivisible cost has size, which buys purchasing terms and nothing that a competitor cannot also buy.
Scale is the most commonly claimed advantage and the most commonly misread. The reading error is to measure it against the world instead of against the market the company actually competes in.
Two companies, one of which has scale
| National company | Regional company | |
|---|---|---|
| Total revenue | 3,000 | 400 |
| Revenue in the region both serve | 60 | 400 |
| Share of that region | 13% | 87% |
| Distribution cost in the region, fixed | 50 | 50 |
| Fixed cost per unit of regional revenue | 83% | 12.5% |
The national company is seven and a half times larger and is the one being outcompeted, in the only market where they meet.
The cost that has to be indivisible
Mauboussin, Callahan and Majd put indivisibility at the centre of it. Economies of scale are particularly relevant for businesses with high fixed costs, and one important determinant of fixed cost is indivisibility in production: a company cannot scale its production costs below a minimum level even if output is low.
Their example is a bakery. To serve a region it needs a bakery, trucks and drivers. Those parts are indivisible, so the cost is borne whatever the demand looks like, and filling a half-empty truck barely changes it.
That is what makes share of a market a barrier and not just a nice position. The challenger has to pay the same indivisible cost to compete at all, and spreads it over fewer units until it wins share it can only win by pricing below a cost it cannot yet cover.
The test to run
Ask what the competitor has to buy in full. If the answer is nothing, and the market can be served incrementally, then scale is a purchasing advantage rather than a barrier, and purchasing advantages are available to anyone who reaches a moderate size.
Then ask what share of the relevant market the company has. Not the global market, and not the market as the company's own investor presentation defines it: the market where a customer chooses between this company and one other.
Where scale is fragile
A scale advantage built on a regional fixed cost dies when the region stops being the unit of competition. That is what a change in distribution technology does: it replaces a cost that had to be paid per region with one that can be paid once and served everywhere.
Which is why this is the advantage most often destroyed by something that looks, from inside the industry, like a distribution change rather than a competitive attack.
Check yourself
Why is a national company with 13 percent of a region at a disadvantage to a regional one with 87 percent?
- Because national companies have higher overheads
- Because the indivisible regional cost is spread over far fewer units in the market where the two actually meet
- Because regional companies are better managed
Show the answer
Answer: B.
Scale is relative to the market being competed in. Total size across markets does not lower the cost per unit in any one of them.What makes a fixed cost create a barrier rather than just operating leverage?
- Its size
- Its indivisibility: a competitor must pay it in full to serve the market at all
- That it is capitalised rather than expensed
Show the answer
Answer: B.
Mauboussin, Callahan and Majd describe indivisibility as a company being unable to scale production costs below a minimum level even at low output, which is what forces a challenger to lose money while gaining share.What most often destroys a regional scale advantage?
- A competitor with more capital
- A change that stops the region being the unit of competition, so the cost no longer has to be paid per region
- Higher input prices
Show the answer
Answer: B.
When a cost that had to be borne in each region can be paid once and served everywhere, the share that produced the advantage stops mattering.Sources
- Mauboussin, Callahan and Majd, Measuring the Moat, Credit Suisse, 1 November 2016: production advantages, process and scale economies, and indivisibility with the bakery example.
What this leaves out
- Every figure in this lesson is invented and round, and both tables are labelled illustrative. No company's filed figures appear.
- Market share as used here is share of the market where a customer actually chooses between two suppliers, which is rarely the market a company reports.
- Nothing here is advice about any security.