Value Investing – Economies of Scale (Lesson 24)
Of the basic business principles, economies of scale has the greatest impact on profitability over any other business principle. As an enterprise’s investment is spread over higher volume the cost per unit of production decreases. The differential between sales price and cost changes add to the overall profitability for the company.
Economies of scale exists in two distinct forms. One isn’t reported in the financial statements and is referred to as the ‘learning curve’. The second form is identified in the financial reports and is called ‘leverage’. When both forms exist in a business and tweaked to perfection, efficiency is maximized and therefore profits reach optimum peaks. Once achieved, the business must exercise the same forms of scale as they grow from a start-up to a publicly traded company.
Learning Curve
Children are the perfect examples of how learning works. After failing in their first attempt they’ll try a different tack until they achieve success. With each attempt the time decreases significantly at first, then marginally after achieving success; basically they get faster. It is human nature.
This same behavioral process exists in business. It exists in all aspects of operations, management and ownership. If management utilizes the feedback loop, the decision process continuously improves and the positive results are economies of scale. To illustrate this the reader needs to understand how the learning curve is applied in operations, management and in overall ownership.
Operations
With operations the learning curve is demonstrated in small incremental steps. Simple human movements (ergonomics) increase speed and effectiveness. Better employees are always looking for ways to make their jobs faster and easier. Even the custodian finds ways to be more effective such as timing of cleaning, frequency or using stronger detergents. The curve is constantly in action.
The goal is to maximize human energy for peak performance thus reducing the cost per unit of production. An illustration is prudent:
In a pizza shop one of the employees notices that when an employee took a phone call for an order, the employee would take the order, wash his/her hands, make the pizza and spend time rotating the pizzas in the oven. There are five employees working, each responsible for the order they took on the phone. After observing this pattern for several days he suggests dividing up the work process. This allowed one person to be focused on producing pizzas reducing his hand washing frequency. One person took the calls, one made the pizza, another cooked/rotated and boxed the pizzas. A fourth checked the customer out at the register. Instead of five, now the same workload is performed by four employees. Here is the math:
Prior Method
Pizza Production per Hour 18
Hourly Wage Per Worker $12.00
Five Workers Wages/Hour $60.00
Cost Per Pizza $3.33
New Method
Pizza Production per Hour 18
Hourly Wage $12.00
Four Workers Wages/Hour $48.00
Cost per Pizza $2.67
The new method reduces the labor cost per pizza by 66 cents. Over a course of a single night serving 70 pizzas the pizza shop saves $51 in labor. Extrapolate this value over a couple hundred nights in a year and the profit increases $10,200.
For those of you not familiar, the process change illustrated above is referred to as division of labor. Basically, the business scaled the labor and generated a positive economic return.
Management
Management learns from their decisions too. If willing to try new approaches to problems and test different methods management can continuously improve operations which scales the business up for more profits.
Continuing with the same pizza shop, suppose the demand for pizzas increases to 36 pies per hour for three hours on Friday and Saturday nights. The shop’s problem is the inability of the existing oven to handle that volume. The oven can only handle 20 pizzas per hour. One option available to management is to replace the existing oven with a conveyor drive oven that can process 42 pizzas an hour at a cost of $4,800.
Can the pizza shop gain economy of scale converting to a new oven system if the contribution margin is $5.00 per pizza?
The answer is a simple math problem. The marginal increase is 16 pizzas per hour (36 pies per hour less the volume from the traditional oven of 20 pizzas per hour) for three hours, two nights a week at $5.00 per pizza. Therefore: 16 pizzas * 3 hours * 2 nights * $5 each = $480 per week. In ten weeks the new oven is paid off. Now the pizza shop is scaling up production by expanding capacity.
Management needs to be careful because all production exists within relevant ranges. Using the same situation above suppose the demand for pizzas is actually 21 an hour for three hours per night, two nights a week. Is there an economy of scale now?
Answer: One additional pizza generates a marginal gain of $5 per hour times 3 hours a night times 2 nights per week which equals $30.00 per weekend. It will take 160 weekends (3 years) to pay for the new oven. Under these circumstances, purchasing the new oven would be a mistake. There is a range of production in business that has a bearing on economy of scale. In the case illustrated the new oven would operate at the low end of capacity whereas the existing oven operates at its high end of capacity. Economy of scale is more efficient at the higher end of capacity. But often the real value of the learning curve comes for the top of the company; the owners.
Ownership
Owners of small businesses reap huge profits when the owners learn from their mistakes. If they are willing to change and adapt to what is wanted or even what works well, the profits can soar. Often owners fail here, more out of pride than anything else. They often refuse to believe that their original idea is a low performer or even a failure and just like the captain of the ship they go down in the sinking.
But if willing to learn and change, they can garner the value of changing to what generates real value. The following is a true story the facilitator experienced, only the name of the company was changed to protect the owners.
Advanced Restoration performed water, fire and storm damage repair services for insurance companies. I was hired as the controller. Once I learned about the industry and the respective nuances I converted the accounting system to class accounting. Basically, I recorded jobs based on the three major divisions of work. After one year of information I determined that water based work (flood damage, water leaks, etc.) generated significantly greater profits. The two owners, Ray and Fred, were at an impasse as to how to proceed.
Ray was interested in the volume of revenue. The business had grown to $3 Million in sales per year in less than three years. During that three year period total losses exceeded $250,000. Fire damage jobs had much greater revenue per job due to structural damage. Ray desired more fire damage work because the average sales volume per job was two to three times more than water based work.
Fred was more conservative and had deeper pockets. He had much more at risk. Explaining to him the math involved and his knowledge of construction influenced Fred to shift towards more water work. It was to no avail. Ray’s adamant position that higher revenue meant profits in the long run won out. He firmly believed that economy of scale was revenue driven.
After two years of working there I estimated, knowing Fred’s personal wealth position, the company had maybe a year left at best. The revenues were much higher but now the losses were getting larger and the cash flow tighter. Ray refused to accept the obvious and Fred’s loyalty to Ray predetermined a certain fate. The business lasted a little longer than one more year.
In this real life example, Ray thought the economy of scale exists in the form of higher revenue. Economy of scale is a function of any one or more business attributes that drive profits higher. It is not limited to revenue.
GREATER REVENUE IS NOT THE SOLE PERFORMANCE FACTOR IN GENERATING ECONOMIES OF SCALE. ECONOMIES OF SCALE IS A FUNCTION OF MAXIMIZING PROFITS WITH THE LEAST AMOUNT OF RESOURCES.
The learning curve is most often exercised via people, processes and product as illustrated in the examples above. But most business entrepreneurs equate economies of scale to the financial aspect of business.
Financial
The most common interpretation of ‘Economy of Scale’ is financial based. Simply stated, invest more capital, ramp up operations and generate more profit per unit of production.
Financial investment into more equipment or having additional working capital can speed up production. Greater production generates more margin which then covers overhead costs quicker adding to the bottom line sooner. All of this is predicated on demand from customers for the product or service. This is why novice business owners are adamant about volume and not efficiency. In the majority of cases volume does generate economies of scale, but to truly peak profits businesses must do both, generate efficiency and expand volume. As an example:
Corey owns a carpet cleaning operation with two vans and steam cleaning mounts (actual pump and suction system mounted inside the van). Each van/mount system costs $40,000. Corey has seen growth in business over the past few years. Each unit (van/mount system) generates $170,000 in sales per year on average with a contribution margin of $90,00 per unit.
His accountant has advised him that to cover the costs of adding another unit to the business would necessitate an additional $75,000 in sales. This is a 23% increase in volume for the carpet cleaning company. Is it realistic for a small carpet cleaning operation to increase volume 23% in a single year? It is highly unlikely, maybe in two years but one year is unrealistic. Corey should expect severe losses during the first year of operations.
If Corey could generate an additional $170,000 in sales for this new unit, his contribution margin would increase $90,000. Overhead costs would remain relatively stable and his bottom line would increase $90,000 adding significantly to his personal income. For Corey, there are other forms of non-capital investment that can generate additional profits; in effect, greater efficiency.
Other Forms of Economies of Scale
The single most unproductive aspect of carpet cleaning is the actual up time for cleaning. In a typical day about 15% of the van’s utilization is a function of driving between jobs. What if their were less jobs but more production at each job? This is where other forms of economies of scale can benefit the bottom line.
- Knowledge – Having the right people on staff trained in other areas of expertise can generate economies of scale.
Corey decides to add additional accessories to his mounts and now cleans upholstery, curtains, throw rugs and blinds. The technicians receive training for these additional services. Over time each unit increases its on-site time and revenue per job, thus increasing the efficiency per unit.
- Certification – Exclusive recognition by higher authorities for acceptance as a member or associate can also create an economy of scale.
After several years of classes and testing Corey is granted certification to remove blood and human tissue/fluids. He then submits his business certification to the local governments, morticians and insurance companies. Now he uses his equipment to clean up crime scenes, suicides, accidental and natural deaths.
Corey passes the test for water damage cleanups and insurance carriers include them on their list for homeowner water damage emergency extraction and drying.
- Experience – Experience (like a child learning from their mistakes) allows owners to master the learning curve. In Corey’s case, he has learned that educating the customer about cleaning and household hygiene generates more frequent requests for carpet cleaning and more extended thorough services while the technician is on-site.
- Heart – Loyalty and trust bind customers to businesses. In Corey’s case, over time some regular customers simple left their key for the technician to enter the house. One of his technicians even went so far as to walk the customer’s dog. In return the customer generated several referrals.
After reading the above, the reader will surmise that these four other methods are a form of the learning curve principle.
Summary – Economies of Scale
Economies of scale is not solely a function of revenue. It refers to maximizing production with the least amount of resources. There are two forms of scaling. One form involves scaling up operations via the learning curve. This includes efficiency with human ergonomics or equipment utilization. It also refers to management learning new approaches to processes. Owners can make a difference with what they learn about business, whether to change the service or product or financially leverage the business. All of these generate economies of scale.
The second form of scaling refers to the traditional definition which is an investment of capital to expand operations and grow sales to cover the additional costs of capital. Any marginal contribution after covering these costs add additional dollars to the bottom line. Act on Knowledge.