This article first appeared on Advisor Perspectives.
“The moat in a business like our auto insurance business at GEICO is low cost. I mean people have to buy auto insurance, so everybody’s going to have one auto insurance policy per car basically, or per driver. And…I can’t sell them twenty…but they have to buy one. What are they going to buy it on? They’re going to buy it based on service and cost. Most people will assume the service is fairly identical among companies, or close enough, so they’re going to do it on cost, so I gotta be the low cost producer. That’s my moat. To the extent my costs get further lower than the other guy, I’ve thrown a couple of sharks into the moat.” – Warren Buffett(emphasis ours)
In our previous article in our series on sustainable competitive advantages, we identified six distinct sources of competitive advantages. This article focuses on one of those sources: economies of scale.
Economies of scale: A widely discussed framework
Economies of scale is possibly the most widely discussed of the competitive advantages. A Google search returned a mind-boggling 48 million results. So, what is the meaning of economies of scale?
Here is how investopedia defines economies of scale: “Economies of scale is the cost advantage that arises with increased output of a product. Economies of scale arise because of the inverse relationship between the quantity produced and per-unit fixed costs; i.e. the greater the quantity of a good produced, the lower the per-unit fixed cost because these costs are shared over a larger number of goods. Economies of scale may also reduce variable costs per unit because of operational efficiencies and synergies.”
The basic tenet is that the cost per unit declines as output increases. The lower cost per unit is largely driven by the presence of fixed costs within the business’s cost curve. Figure 1 shows the concept of economies of scale by plotting the cost per unit in relation to the production volume.
Figure 1: Economies of scale; Declining costs with increasing output
Analysis framework: Economies of scale and sustainable competitive advantages
There is a nearly unanimous view on what amounts to economies of scale: lower cost per unit in response to increased operational scale. However, as investors, specifically as investors focused on identifying high-quality businesses, we need to ask a question: While lower cost per unit with increasing operational scale is a necessary condition for economies of scale, is it a sufficient condition for a sustainable competitive advantage?
Reread the quote by Warren Buffett at the beginning of the article. Pay special attention to the emphasized statements. The first emphasized statement relates to the demand for the product or the service offered by the business. What Buffett is saying is that there have to be factors that protect the demand such that the demand will sustain. Clearly, no matter how low one’s cost of production is in relation to its competitors, it will be a poor business if the customers don’t need the product or the service any more.
The second emphasized statement is related to the costs of the business in comparison to its competitors. As discussed by Buffett elsewhere, cost advantages that are easily replicable do not lead to sustainable competitive advantages. If everyone can replicate these cost advantages, everyone will. This will lead the cost curve of the entire industry to shift lower such that there is no competitive advantage.
For cost advantages to lead to sustainable competitive advantages, two elements need to be present: the efficient production unit (EPU) and steepness of the cost curve.
- Efficient production unit (EPU)
Related to the concept of economies of scale is the opposite concept of diseconomies of scale, when cost per unit increases as operational scale increases. Before diseconomies of scale kick in, there is the point of the optimal scale. We refer to this point as the EPU. Figure 2 shows the EPU with the cost per unit plotted in relation to the operational scale.
Diseconomies of scale don’t always take hold. Indeed, in many industries, after a certain size is reached, the cost curve flattens such that the business operating at or beyond the EPU continues to maintain the status of being one of the lowest cost producers.
Figure 2: Economies of Scale; MAEG’s Framework
Why is the EPU relevant? It dictates the structure of the industry and consequently determines whether or not the business will end up with a competitive advantage. Below, we reproduce our note on the industry structure of auto manufacturers we discussed in our article on Entry and Exit Barriers:
“Consider the case of automakers, an industry characterized by substantial entry barriers. One of the sources of entry barriers protecting auto makers is the cost of development of new models. The development cost of a new model varies significantly. Depending on the scope and complexity of the project, the costs of developing a new model can range from US$1 billion to US$6 billion .
To be a viable competitor and occupy enough mind-space of consumers, an automaker requires about five to six models. Assuming the development cost per model of US$2 to 3 billion and useful life of a new model of five years, an automaker will need to sell 2.4 to 3.6 million vehicles per year in order to keep the development cost per vehicle down to US$1,000. With the U.S. market currently estimated at about 18 million passenger vehicles per year , the market can accommodate five to six competitors.”
The EPU for the auto industry is above 2.4 million vehicles per year. The size of this scale in relation to the size of the industry will dictate the structure of the industry. Clearly, an industry that is large enough to accommodate a multitude of players operating at or above the EPU is unlikely to give rise to sustainable competitive advantages based on economies of scale. The reason for this assertion is that the benefits of lower costs in such industries are likely to be passed on to the customers. This is especially true when the industry is also characterized by the presence of strong exit barriers.
- Steepness of the cost curve
Let’s say that we have a business with economies of scale and that the EPU is large enough to accommodate only a few players. Surely, we have the makings of a good business, right? Not necessarily. The next rather subtle and important factor is the steepness of the cost curve. Unless the cost differential between the efficient and inefficient players is large enough to allow the efficient player(s) to earn a fat return on capital, we still do not have a high-quality business on our hands.
Referring back to Figure 2, the cost differential between the cost leader vs. the second and third best players as well as the inefficient players needs to be large enough to allow for the cost leader(s) to earn excess profitability.
Analysis framework: Ancillary elements
As widely discussed as the framework of economies of scale is, it is also the most misused of the competitive advantage frameworks. In a so-called flat world, economies of scale have been repeatedly abused to justify international expansions or to make acquisitions. In addition to the discussion above, the following elements should be considered as well when considering economies of scale as a source of competitive advantage. Note that what follows is not an exhaustive list of ancillary factors.
- Presence of additional entry barriers
In general, economies of scale is a weaker moat than other sources. Primary entry barriers in case of economies of scale are driven by the amount of capital to be committed and rationality of potential entrants. Indeed, if the business is characterized by strong exit barriers, such businesses can very quickly morph into businesses with very poor economics when a new entrant attracted by excess returns of the incumbent commits capital and the resultant excess capacity is unable to exit.
However, if the scale of the business is protected by additional ancillary entry barriers (e.g., distribution capability, customer relationships, reach to customers, etc), such moats can last for extended periods.
- Mature versus emerging markets
Economies of scale driven moats are likely to be weaker in emerging markets as compared to mature markets. This hypothesis is related to the concept of EPU discussed earlier. The higher market growth rates of emerging markets mean that the size of the industry will increase rapidly in relation to its EPU such that an industry that could previously only accommodate one or two players, will be able to accommodate many more. This may lead to a loss of the competitive advantage.
For this discussion, it is instructive to consider the case of the auto manufacturers industry in India. For a long period of time, Maruti Suzuki India Limited (MSIL) had a very strong hold on the entry level car segment with its Maruti 800 car. As the number of cars sold were not enough to accommodate more than one player, MSIL dominated this market. However, as India’s economic growth accelerated, the improved economic position of the middle class of the industry meant that the number of entry level cars sold increased at a rapid rate. As the EPU got progressively smaller in relation to the size of the industry, several new competitors entered the space, most notably Tata Motors and Hyundai.
Application of the framework: Shoprite Holdings Ltd
The Shoprite Group of Companies, Africa’s largest food retailer, operates 1,825 corporate and 363 franchise outlets in 15 countries across Africa and the Indian Ocean Islands. The primary business of the Shoprite Group of Companies is food retailing to consumers of all income levels. We characterize Shoprite as a business that possesses sustainable competitive advantages driven by economies of scale.
Figure 3 shows the estimation of EPU for Shoprite. As per our estimates, Shoprite is currently operating around the EPU level. Shoprite is the largest player in the industry followed by Pick and Pay and Spar. Massmart is another player in the industry. However, it has a different format with Massmart stores being considerably larger than Shoprite stores.
Figure 3: Shoprite, Estimating the EPU
As shown by Figure 4, Shoprite has the lowest cost per unit of sales as compared to all other players with the cost per unit curve being fairly steep for the retail business.
Figure 4: Shoprite, Steepness of the Cost Curve
Figure 5 shows the cost curve for the year 2010. It is important to note here that compared to 2010, Shoprite widened its cost advantage over its competitors.
Figure 5: Shoprite, Steepness of Cost Curve, 2010
While declining costs with increasing operational scale lead to economies of scale, not all economies of scale are created equal. The analyst needs to dig deeper and understand the structure of the marketspace in which the business competes to understand whether or not such economies of scale lead to a sustainable competitive advantage. Having a framework in place and a consistent application of it are good starting points.
 “Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industry wide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational. After each round of investment, all the players had more money in the game and returns remained anemic.” – Warren Buffett discussing the Berkshire’s textile businesses. http://www.gurufocus.com/news/146134/warren-buffett-lesson-from-the-textile-business
 Note that for the purposes of this analysis, our reference to emerging and mature markets is not limited to geographical classifications. Indeed, an industry that is growing at high rates will also fit our classification here.