How Economies Of Scale Provide Competitive Advantages

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.

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