An investor who finds a company with economies of scale may have found a company with a competitive advantage.
In chapter three of “Competition Demystified: A Radically Simplified Approach to Business Strategy,” Bruce Greenwald and Judd Kahn explored what economies of scale are, as well as their strengths and weaknesses. Investors will find this knowledge helpful when trying to determine if a company has a competitive advantage (aka a moat).
As noted in chapter one of the book, economies of scale is one form of a barrier-to-entry advantage; the other two are supply advantages and demand advantages, as described in chapter two. As the authors explained, competitive advantages from supply and from demand are relatively simple; they have sustainably lower costs, or they enjoy customer captivity.
More powerful than either of those, they argued, is a linkage between economies of scale and customer captivity. The essence of this linkage is about market share and the “scale” of operations. Companies with more market share can spread their costs over more units than companies with less market share, keeping prices down and maintaining the loyalty of customers.
A software company, for example, has high fixed costs and low variable costs; the software must be written and checked before the first copy is sold, but once sales begin, it costs very little (in variable costs) to make each additional copy.
Once the software company begins to grow, its expenses increase slowly, no matter how many customers they have. With that growth, the original fixed costs are spread over more units, while the variable costs stay nearly flat and the cost per unit declines.
But there is a sticking point. This assumes that all entrants have full and equal access to customers, as well as common cost structures. For an incumbent established in a market, equal access would wipe out its competitive advantage, so it needs customer captivity to retain its market share. As long as the dominant firm can hold onto its customers, new entrants will be frustrated.
Greenwald and Kahn pointed to the example of the American auto industry, which did not defend its market position and allowed Japanese rivals to grab a significant amount of market share. To cite a couple of other examples from the 1980s, they noted how Fuji took market share from Kodak (KODK, Financial) and how Bic (BB, Financial) disposable razors undercut Gillette (PG, Financial).
A couple of companies that were able to defend their market share with economies of scale were Walmart (WMT, Financial) with its “everyday low prices” and Southwest Airlines (LUV, Financial) with its aggressive discounting.
In general, the authors recommended that dominant companies being challenged should match their aggressive competitors by matching every pricing and product initiative. With customer captivity, the dominant firm should maintain its market share. Its profits may fall, but those of the challenger likely will fall further, perhaps even to the point of being forced out of business.
Economies of scale also extend to distribution and advertising. They explain that while small rivals might be able to keep up to the big, dominant firms on some measures, they can spend only a fraction of what giants like Kellogg’s (K, Financial), McDonald’s (MCD, Financial) and Coca-Cola (KO, Financial) can.
Defenders (incumbents) must take three key steps, according to Greenwald and Kahn:
- Defend against any intrusion that might affect their competitive advantages. When smaller rivals introduce new products, the incumbent must quickly match them, as it must when challengers start new advertising campaigns or new distribution systems. For example, Coca-Cola lost market share in the 1950s because it was slow to respond when Pepsi (PEP, Financial) began using supermarkets as a distribution channel.
- Incumbents must realize that size alone is not the same thing as economies of scale. It is relevant market share that creates economies of scale, not a company’s size in general. For example, Greenwald and Kahn compared IBM (IBM, Financial) and Intel (ITC). When Intel was still a small company, IBM’s total sales were many times bigger than Intel’s, but IBM’s research and development costs covered a much bigger range of products, allowing Intel to win the day.
- Growth in a market can undercut competitive advantages based on economies of scale. This goes back to the fixed and variable cost structures since fixed costs will remain the same but variable costs will grow with the market. That means fixed costs become a smaller component of total costs, lessening the power of economies of scale. Somewhat ironically, the authors reported that economies of scale advantages are most often found in local and niche markets.
Strategically, a couple of courses emerge out of these findings. First, economies of scale advantages last longer than those from supply and demand. There is an important caveat, though, which is that economies of scale advantages are specific to geographic regions, and all economies of scale advantages tend to erode over time. Greenwald and Kahn told us that Coca-Cola may be very popular, but it is not the most popular everywhere. At the time of publication (2005), Korea gave the most market share to a local company that had aligned itself with Pepsi.
Second, advantages of scale may be more sustainable than supply and demand advantages but must be defended because of gradual erosion. For defenders and challengers both, the best strategy is to find a local niche, get established and then expand. That’s the course taken by Walmart. It worked, too, for Microsoft (MSFT, Financial), which began with an operating system before moving into office applications and many other areas. As it did so, it marginalized Lotus and WordPerfect, two original players in the spreadsheet and word processor niches.
Not all niches are created equal. It’s necessary to find one that has potential customer captivity, small size relative to fixed costs and an absence of strong incumbents. In addition, there should be places to expand at the periphery.
For companies that are defending against challengers, effective tactics include pushing up fixed costs such as advertising that make it harder for challengers to compete. Greenwald and Kahn argued that competitors should try to shift as many costs as possible from a variable basis to a fixed basis.
To be effective, though, such plans need to be focused on the right areas for expansion. Many once famous names have faded into obscurity because they expanded into the wrong niches rather than defending the markets where they were strong.
On the other hand, some got it right and stayed close to their competitive advantages. In this category, they listed companies like Kimberly-Clark (KMB, Financial), Walgreens (WBA), Colgate-Palmolive (CL) and Best Buy (BBY). The authors offered these words of wisdom: “Competitive advantages are invariably market-specific. They do not travel to meet the aspirations of growth-obsessed CEOs.”
Conclusion
Economies of scale, one of three types of barriers to entry, was the focus of chapter three of “Competition Demystified: A Radically Simplified Approach to Business Strategy.” Authors Greenwald and Kahn explained the strengths and weaknesses of this strategy.
Three major points were stressed: that economies of scale and customer captivity make a very strong pairing, that economies of scale may be effective but as a defensive position will experience gradual erosion and that both defenders and challengers must have appropriate strategies if they are to prevail.
Disclaimer: This review is based on the book, “Competition Demystified: A Radically Simplified Approach to Business Strategy” by Bruce Greenwald and Judd Kahn, published in 2005 by Portfolio/Penguin Group. Unless otherwise noted, all ideas and opinions in these reviews are those of the authors.
Read more here:
- Competition Demystified: Advantages in Supply and Demand
- Competition Demystified: Strategy and Competitive Analysis
- High Returns From Low Risk: Is the Investment Paradox Really True?
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