Continuing the economic moat series, in this article we will take a look at yet another source of durable competitive advantage: the economies of scale moat.

Economies of scale can also be thought of as having a "lowest cost producer" competitive advantage. It goes without saying that price is an important factor in most purchasing decisions. Obviously, all other things being equal, customers will almost always choose the competing good or service with the lower price. In many industries, price is the overriding concern when customers make purchasing decisions, even above quality, convenience, etc. Being the lowest cost producer is a huge advantage in these categories of goods and services.

But how does a company build this advantage? How can we reliably identify it? And how durable is it?

Let's take a look at the ECONOMIES OF SCALE economic moat.

It's All About Costs

Being the lowest cost producer doesn't just mean you can offer a good or service at the lowest cost to the customer. It also means you can PRODUCE the good or service for a lower cost than all your competitors.

There are two kinds of costs in business.

The first are called VARIABLE COSTS. These are costs that scale up and down roughly in line with sales volume. Consider Kellogg's (K) Corn Flakes. For every box of Corn Flakes sold, Kellogg's has to pay for the cardboard, the plastic sleeve, the printing, and the ingredients (88% corn!). If they sell 1 box of Corn Flakes, the variable cost is "V". If they sell 10 boxes of Corn Flakes, variable costs are (V * 10). The costs scale up and down in a more or less straight line.

The second kind of costs are called FIXED COSTS. These are the costs required to produce a minimum amount of product. For something like Corn Flakes, this would represent the machinery used to automate the process of turning the ingredients into cereal, as well as prepare the packaging and package the cereal into the box for shipment.

Whether Kellogg's sells one box of Corn Flakes or 32 million, this machinery is still necessary to make the product. Fixed costs are often referred to as "capacity".

Let's refer to the cost of this production machinery as "F". Kellogg's probably has a Corn Flakes capacity of 40 million boxes or so. However, regardless of how many boxes under 40 million are sold, the cost for the machinery is roughly the same. Therefore, if one box of Corn Flakes is sold, the cost is F. If 30 million boxes are sold, the cost is still (roughly) F.

The key to a cost advantage is in the fixed side of the equation.

Let's say Kellogg's management is targeting a gross profit margin per box of Corn Flakes at 40%, and the competitive environment will allow a price per box of about $3. Management knows variable costs are about $1 per box, or 33%. It also knows that the machinery cost to produce a capacity of 40 million boxes costs about $20 million.

If Kellogg's has a poor year and sells only 10 million boxes of Corn Flakes at $3, their gross revenue is $30 million. Minus variable costs, profits are $20 million (67% margin). Minus fixed costs, that leaves a profit of... $0. Not good! The company would not be in the business of Corn Flakes for long with this kind of result.

On the other hand, if Kellogg's can move 30 million boxes, gross revenue would be $90 million, and after variable costs, profit would be $60 million. After the $20 million in fixed cost, that still leaves a $40 million profit, which is a 44% gross margin. Now we're talking! Kellogg's could easily respond to a competitive threat by lowering price, and still make a healthy take.

This is known as "leveraging fixed costs". It is the key to an economies of scale advantage. While it is true that scale can also lead to variable cost advantages (mainly through price concessions from suppliers for buying in bulk), the fixed side of the equation is most important.

Identifying Economies of Scale Moats

We can see that leveraging fixed costs at a scale that is difficult for competitors to match is really what the economies of scale moat is all about.

But how can we reliably identify one?

The first thing to know is that the economies of scale moat really only applies to a handful of business sectors. It works best in industries that require a lot of fixed capital investment to build the capacity to produce or sell goods efficiently - e.g., high fixed cost businesses. You won't encounter the economies of scale moat much in service-based industries, where costs are highly variable.

Some examples of businesses that can build economies of scale moat include: general retail, manufacturing, transportation, and pharmaceuticals.

Finding economies of scale in these industries is relatively straightforward: you look for the biggest players! These players tend to stand out as having far higher sales volume than their primary competitors. The scale advantage manifests itself in a combination of revenue and gross margin percentage. A firm that can sell far higher volumes while maintaining the similar or better gross margins than its smaller competitors is a good bet to have an economies of scale advantage.

Let's take an obvious example of an economies of scale moat: Walmart (WMT). Walmart is a general retailer, selling everything from clothes to electronics to toys to groceries. It faces a lot of competition, but let's take its closest and most similar competitors: Target (TGT), and Costco (COST).

The first thing we can look at are revenues. Walmart does about $524 billion in sales, vs. Target's $80 billion and Costco's $160 billion. So, right off the bat, we can identify Walmart as having a massive scale over both of its primary competitors.

That's fine and dandy, but is Walmart able to sell at this volume profitably? If we take a look at gross margins, Walmart's is about 25%, while Target's is 30%, and Costco just 13%. So, we can see that Walmart is able to operate at sales volumes over 3x that of Costco and close to 7x that of Target, while still maintaining competitive (and sometimes far better) gross margins.

We can also compare the cost of similar items from these suppliers. Some shopping comparisons have put Walmart and Costco's prices roughly neck-and-neck, but Walmart in general has lower prices than Target. Costco's price parity comes at a cost: the firm's gross margins are far lower, and the business has to rely on a subscription fee model for a substantial (~18%) portion of net income.

Given this huge disparity in sales volume, competitive gross margin profile, and low prices even without auxiliary revenue sources, it is clear that Walmart has an economies of scale advantage. Its larger store base, distribution network, online operations, and ability to get price concessions from suppliers allows it to deliver everyday low prices that keep customers coming back. Costco needs subscription revenues to compete on price, and Target cannot compete at scale with its pricing model. It would be very hard to break Walmart's hold on general retail in any short amount of time.

The Durability of Economies of Scale

Few economic moats are forever. The key is that we can rely on a durable competitive advantage to protect our investment for at least a reasonable holding period - 3 years at least, and hopefully 10 years or more.

As far as moat types go, the economies of scale moat is probably one of the less durable ones.

One trend that has hurt this traditional moat source is globalization. Establishing unmatched manufacturing capacity was a common way to build economies of scale moats in the 20th century. America's big auto makers dominated their markets prior to the 1970's, companies like General Electric (GE) produced appliances at far larger scale than anyone else, even Dell in the 1990's gained fame by producing computers at low cost but enormous volumes.

This changed rapidly as globalization advanced in the latter half of the 20th century into the 21st. Foreign automakers entering the U.S. market has killed any scale advantages in the auto industry forever. Manufacturing has largely moved into lower labor cost locales and become outsourced, removing much potential for scale leverage. Nearly all PC-related manufacturing is outsourced to factories in Asia nowadays.

Technology has also affected the durability of economies of scale. Store chains were once a very good scale advantage, as they efficiently provided a way for product producers to reach the largest amount of potential customers. A store with a large (and expensive to build) distribution and store network had major and durable advantages over smaller chains. But the rise of e-commerce has hurt this business model, as stores have been replaced with easy and cheap to build websites, and distribution networks have been replaced with standard shipping solutions available to everybody at roughly the same cost.

All told, economies of scale is one of the less attractive and less relevant moats in today's economy. While it is true that scale is usually advantageous in any industry, it is not the dominant competitive advantage that it once was. We have very few "green dot" stocks that rely on a economies of scale moat for their competitive advantage. They do exist, but in today's economy they are few and far between.